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For any firm that aggregates portfolios of the same strategy into a composite, or otherwise groups portfolios by mandate, how do you know that each portfolio truly follows that strategy? The answer is outlier testing.

Why Utilize Composites?

The GIPS standards require firms managing separate accounts to construct composites, which aggregate all discretionary portfolios of the same strategy. However, even for firms that are not GIPS compliant, the use of composites is considered best practice when reporting investment performance to prospective clients. Composites offer a more complete picture than presenting performance of a model or “representative portfolio” – which usually leave prospects wondering whether the information is truly representative or if the portfolio presented was “cherry picked.”

When creating and maintaining composites, firms must ensure that portfolios are included in the correct composite for the right time period – the period for which you had full discretion to implement the composite strategy for that portfolio. This is achieved by following a clearly documented set of policies and procedures for composite inclusion and exclusion. However, what happens when changes are made to a portfolio and those changes are not communicated to the person maintaining the composite?

In an ideal world, information in your firm would flow perfectly so that the person maintaining your composites knows exactly what is happening with the firm’s clients. In reality, client requests commonly result in small or temporary changes to the portfolio (e.g., halt trading, raise cash) that are not formally documented in the client’s investment guidelines or investment policy statement.

Without formal documentation of these changes, information may not flow down to the manager of your composites. While these minor or temporary changes may not affect the client’s long-term objectives, they may cause the portfolio to deviate from the strategy, requiring (at least temporary) removal from its composite. When these restricted portfolios are left in the composite, they often become performance outliers and create “noise” in the composite results. This “noise” prevents the composite from providing a meaningful representation of the portfolio manager’s ability to implement the strategy. This will also interfere with your prospective clients’ ability to analyze and interpret your performance results.

Why test for performance outliers?

Testing for performance outliers prior to finalizing and publishing performance results can help your firm remove this “noise” and can prevent costly errors in performance presentations. Firms that lack adequate composite construction policies and controls to ensure the policies are consistently followed often end up with errors in their composite presentations. In fact, it is very likely that errors in your performance exist. It is rare for us at Longs Peak to conduct an outlier analysis where no issues are found. Outlier testing should be completed quarterly and at a minimum, before any related verification or performance examination.

Many firms, especially those that are GIPS compliant, rely on their verifier to catch errors in their composites. We do not recommend this and suggest firms perform testing internally (or with the help of a performance consultant like Longs Peak) because:

1. Verifiers only test a sample and will likely not catch all of your issues.
2. Verification may happen months after the performance has been published. When errors are found, it may require redistribution of presentations with disclosures regarding prior performance errors.
3. When verifiers find errors, they generally increase their sample size as well as their assessment of engagement risk. These two things lead to more time spent on the verification and a potential increase in your verification fee.

Even if not GIPS compliant, when firms use composites, regulators may test to ensure the composites are a meaningful representation of the strategy. In addition to improving accuracy, testing for performance outliers can help your firm‘s composites meet the standards expected by regulators.

How can performance outliers be identified?

Testing for performance outliers involves reviewing the performance of portfolios within the same composite or strategy to test if they are performing similarly. This testing allows you to flag any portfolios that may be performing differently so you can evaluate if their inclusion in the composite is appropriate.

For example, if your firm has a Large Cap Growth composite, testing performance outliers would involve compiling the return data for all of your Large Cap Growth portfolios, identifying which portfolios performed materially different from their peers, researching why they performed differently, and then taking the appropriate action if an issue is discovered. This may sound like a daunting task, but it doesn’t have to be. Let us walk you through this in more detail.

Some firms simply look at the absolute difference between each portfolio’s monthly return and the monthly return of the composite. While this may be straight forward, relying only on the absolute difference to determine outliers does not take into consideration the size of the return and the normal distribution of portfolio returns in the composite. For example, if you set a threshold to look at all portfolios that deviate from the composite return by 50bps, the result for a composite with low dispersion and a total return of 2% would very be different than a composite with higher dispersion and a total return of 20%.

In the outlier analysis Longs Peak conducts for clients, we use standard deviation in conjunction with a comparison of the absolute differences to identify the outlier portfolios that require review. Utilizing standard deviation allows us to identify portfolios that are truly outside the normal distribution of returns for each period. For example, reviewing all portfolios that are more than 3 standard deviations from the composite mean will provide the portfolios outside the normal distribution of returns for that period, regardless of the size of the return or the level of dispersion in that composite.

What to consider when reviewing outlier performance

The severity of the outlier

The larger the outlier, the more likely it is that the portfolio has an issue that would require it to be removed from the composite. We typically start by looking at the most extreme outliers first. Generally, we look at portfolios with performance periods flagged with +/-3 standard deviations from the mean return for the period. By addressing these first (including removing them if it is determined they do not belong in the composite), we are able to re-run the outlier test to assess what outliers exist without these extreme cases disrupting the analysis.

Once these extreme outliers are addressed, we move on to review the portfolios that are +/-2 standard deviations and even +/-1.5 standard deviations, if needed. We keep reviewing accounts with returns closer and closer to the composite’s mean return until we are consistently confirming that the portfolios do in fact belong in the composite and errors are not being found.

Each firm will be different in how much they need to drill down to get to a point of comfort that no more errors exist. If your composite is managed strictly to a model, the outliers will be very clear and easy to identify. If each portfolio you manage is customized, more research is often needed to determine if the outlier performance is simply a result of the portfolio’s customization or if the portfolio was included in the wrong composite.

How often the portfolio is an outlier

Longs Peak’s performance outlier reports show a portfolio’s performance, the number of standard deviations it is from the mean each month, and the number of months the portfolio was an outlier throughout its history in that composite. Our reports also show whether there was a cash flow during that period or not. The following are examples of outlier frequencies we evaluate:

Infrequent: If you see that a portfolio is only an outlier for one month and that month had a large cash flow, then you will know that the portfolio is likely only an outlier for that period because of the cash flow and, often, no further research is required.

Frequent: If you can see that the portfolio is an outlier for most of the months under review, then you will know that there is likely an issue with this portfolio.

As of a specific date: If you can see that the portfolio was not an outlier historically, but became a frequent outlier from a certain month forward, this may indicate that a restriction was added or that the strategy changed as of that period. The portfolio may then need to be reclassified to the appropriate composite or flagged as non-discretionary.

The most common causes of outlier performance and how to address performance outliers

Common causes of outlier performance:

• Data issues – When outliers are extreme, it is likely that there is an issue with the data. Examples include a pricing issue that caused a material jump in performance or a late dividend hitting a portfolio that is closing and had most of its assets already transferred out. These issues are often easily addressed, depending on the circumstance of each case.
• Cash flows – If a portfolio is only an outlier for one month and during that month the portfolio experienced a large cash flow, this is likely the reason for the outlier performance. If the portfolio had high cash for a period of time around the cash flow and the market moved during that period, this portfolio likely would perform differently than its fully invested peers. Nothing needs to be done in this scenario since the outlier performance is explained and there is no indication that the portfolio is invested incorrectly or grouped with the wrong portfolios.
• Legacy positions or other client restrictions – If your clients hold legacy positions that you are restricted from selling or have other similar restrictions, this will likely cause these portfolios to perform differently when compared to their unrestricted peers. Depending on your composite construction rules, unless immaterial, these portfolios likely need to be excluded from the composite. With these portfolios removed, other outliers may appear that were not as noticeable when the restricted portfolios were included. It is important to refer to your firm’s composite construction policies, which should outline clear parameters for when restricted portfolios should be included/excluded in composites.
• Portfolio categorized incorrectly – A portfolio may appear as an outlier because it was placed in the wrong composite. This often happens if a portfolio’s composite changed and it was not removed from its prior composite. If this is the case, the portfolio must be removed (after the change) and added to the new composite based on the timing outlined in your firm’s composite construction policies.
• Portfolio managed incorrectly – Performance outlier analysis may help identify a portfolio that is managed to the wrong strategy. For example, it is possible that the portfolio is grouped with the correct portfolios, but the wrong strategy was implemented in the portfolio. This is one of the most important errors that performance outlier testing can identify because it means that the client is actually not having their money managed to the strategy for which your firm was hired. In this case, the portfolio would need to be rebalanced to the correct strategy. Likely, a review of the history would need to be conducted as well to ensure the client was not disadvantaged by the error.
• High dispersion between portfolio managers – Especially when more than one portfolio manager is implementing the same composite at your firm, material differences may exist in the way they each manage the strategy. Outlier performers may be due to differences in the portfolio managers’ discretionary management. If the composite is being sold as one cohesive product, it is important to identify where the portfolio managers deviate and determine if they can work more closely together to avoid high dispersion or if the strategy should actually be run as two different products.

When researching outlier performance, keep in mind that, on its own, a portfolio’s performance deviating from its peers is not a valid reason to remove the portfolio from its composite. You need to determine the root cause of the deviation and remove the portfolio from its composite only if the root cause was client-driven. If the deviation was caused by tactical, discretionary moves made by the portfolio manager, the portfolio must remain in the composite as its performance is still a representation of the portfolio manager’s implementation of the strategy.

Ready to implement performance outlier testing at your firm?

While it is best practice to create a flow of information that will allow portfolios to proactively be included/excluded in the correct composite at the appropriate time, testing for performance outliers acts as a back-up plan to catch anything that was missed.

If analyzing your composite data to identify performance outliers is not something you have the resources to do internally, Longs Peak is available to help. Longs Peak offers both consulting and reporting services that can assist your firm with outlier analysis. Conducting outlier analysis should be done at least quarterly to help ensure your firm is managing your portfolios consistently and are reporting strategy or composite performance that is meaningful and accurate. Please contact us to discuss how we can help implement this practice for your firm.

Questions? 

If you have questions about investment performance, composite construction, or the GIPS standards, we would be love to talk to you. Longs Peak’s professionals have extensive experience helping firms with all of their investment performance needs. Please feel free to email Sean Gilligan directly at sean@longspeakadvisory.com.

The 2020 edition of the Global Investment Performance Standards (“GIPS®”) was released to the public at the end of June 2019 and with it comes a number of changes that firms will need to address. To maintain compliance with the GIPS standards, firms must make the required changes necessary to follow all requirements of the 2020 GIPS standards prior to presenting information through 31 December 2020 in their firm’s GIPS Reports.

All firms and asset owners complying with the GIPS standards will be required to at least make some changes to disclosures and the terminology used in their GIPS policies and procedures. Some firms will require more work. The following questionnaire is designed to help firms determine if converting to the 2020 GIPS standards will require more than a few minor tweaks for their firm. This list does not include all changes, but includes the top ten material changes that may require a project plan to be put in place to be able to implement the required changes by the effective date of the 2020 GIPS standards.

If your firm answers “Yes” to any of the following questions, a project plan should be established to address how the 2020 changes will be implemented at your firm prior to presenting 2020 performance in your firm’s GIPS Reports:

Key Questions to Consider

1. Does your firm have limited distribution pooled funds (i.e., private funds that are not regulated under a framework that would permit the general public to purchase shares in the fund without a one-on-one presentation)?
2. Has your firm created single account composites for pooled funds solely for the purpose of meeting the GIPS requirement of having every discretionary, fee-paying portfolio in at least one composite?
3. Does your firm have multi-strategy portfolios (e.g., balanced portfolios where the equity and fixed income segments each could be represented as standalone strategies) where you would like to carve-out the individual strategies into their own composites?
4. Does your firm have portfolios where actual transaction costs are unavailable (e.g., wrap accounts or other bundled fee arrangements)?
5. Does your firm have portfolios where your firm controls the amount and timing of external cash flows (other than for private equity or real estate)?
6. Does your firm have real estate or private equity composites?
7. Does your firm include theoretical performance (e.g., model performance) as part of a GIPS report?
8. Does your firm follow the Advertising Guidelines to claim compliance with the GIPS standards outside of your GIPS reports?
9. Does your firm currently update your GIPS compliant presentations more than 12 months after the year ends?
10. Does your firm have advisory-only assets or uncalled committed capital you wish to present in your GIPS Report?

Need Help Navigating or Implementing the 2020 GIPS Standards?

As a consulting firm specialized in investment performance and the GIPS standards, Longs Peak Advisory Services (“Longs Peak”) is available to help implement the 2020 GIPS standards for your firm. Verification firms are required to remain independent, which means they can provide your firm with advice, but they cannot actually “get their hands dirty” making the changes for you.

Whether you answered “Yes” to any of the questions above or if you just need help with the minor tweaks all firms need to make, Longs Peak is available to help. Please reach out to us and we can create a project plan to help your firm prepare to comply with all requirements of the 2020 GIPS standards.

It has been a busy couple of weeks for GIPS! On August 31^st, the Exposure Draft of the 2020 Global Investment Performance Standards (GIPS®) was released for public comment and last week (September 14^th and 15^th) was the GIPS conference. With this exposure draft being released only two weeks before the conference, the forthcoming changes to the GIPS standards were the highlight of the event.

UPDATE: Notes have been added in red to clarify what has been adopted or modified now that the 2020 GIPS standards have been published.

Why are changes to the GIPS standards necessary?

The three primary reasons GIPS standards are being revised is to make them:

1. Easier to understand: GIPS compliant firms are required to comply with all of the requirements of GIPS, including issues addressed in Guidance Statements and Q&A’s. Since the 2010 Standards were published, there have been several new Guidance Statements and many Q&A’s issued, which can be difficult for firms to follow. The GIPS 2020 re-write of the Standards is reorganized to avoid having to refer to several different sources to understand what is required.
2. More relevant for different types of investors: GIPS was intended to be a global standard that is applicable to any type of investment manager, regardless of location or type of investment strategy managed. Despite this intention, GIPS has historically been focused on presenting composite performance, which is only really relevant when marketing a strategy to prospective segregated account investors. GIPS 2020 differentiates between marketing a strategy to potential segregated account investors versus marketing an established pooled fund to prospective fund investors. It also separates out the requirements for Asset Owners who present performance to their oversight board instead of prospective investors.
3. More consistent across asset classes: In some cases, the Standards have been overly focused on asset class in specifying calculation methodology and valuation requirements where investment vehicle structure and external cash flow control are perhaps more important than the underlying investments. By removing asset class specific requirements for private equity and real estate, the Standards can be applied more appropriately and in a more consistent manner.

What is changing with GIPS?

To be clear, nothing is changing yet. The purpose of the exposure draft is to introduce proposed changes. We are all invited to provide comments during the public comment period (open through December 31, 2018) to ensure our voices are heard before any of these proposed changes become official. Below are some highlights of the most significant proposed changes:

Asset Owners 

While this is largely just a formatting change, the reorganization of how the requirements for Asset Owners are documented will make it significantly easier for Asset Owners to understand and apply GIPS to their organizations. Specifically, GIPS 2020 separates the requirements for Investment Management Firms and Asset Owners, allowing each type of firm to review the provisions applicable to them and see all requirements in one place. Since there are many redundancies between the two sections, this makes the Standards much longer, but easier to read since only the sections of the provisions applicable to them needs to be reviewed. Previously, Asset Owners were required to start with the Standards that were written for investment managers and then remove or adjust the requirements that were not applicable for them. It is now easier for Asset Owners to understand what applies.

UPDATE: This change was adopted as part of the 2020 GIPS standards.

Managers of Pooled Funds 

Previously, GIPS compliant firms were required to create composites for pooled funds even if the pooled fund would be the only constituent of the composite. GIPS 2020 no longer requires these composites to be created. Managers of limited distribution pooled funds will instead create a GIPS Pooled Fund Report that presents the information of the fund itself for prospective investors together with required GIPS disclosures for this type of report. Managers of broadly distributed pooled funds are not required to create a special report for GIPS. This will save managers of pooled funds a lot of time and effort and will allow them to create meaningful presentations focused on the funds themselves rather than creating composites that would likely never be used.

UPDATE: This change was adopted as part of the 2020 GIPS standards.

Option to present MWR

Previously, only Private Equity funds presented Money-Weighted Returns (“MWR”) (a.k.a. Internal Rates of Return (“IRR”)). GIPS 2020 removes all asset class specific rules and focuses more on the structure of cash flows and the type of vehicle used. For example, under GIPS 2020, if a firm manages a closed end fund where they control the external cash flows, they will have the option to present MWR instead of TWR, regardless of the type of underlying investments being made. In cases where the manager controls the timing and amount of the cash flows rather than the client, MWR is likely a more meaningful performance measure since it does not remove the effect of the cash flows the way TWR does.

UPDATE: This change was adopted as part of the 2020 GIPS standards.

Valuation Requirements

Previously only the Real Estate provisions included a requirement for external valuations. Since all asset class specific rules have been removed, the external valuation requirement now applies to all private market investments. To make this manageable, what is accepted as an “external valuation” has been loosened to include annual financial statement audits. This means that as long as the fund is audited, no separate external valuation should be required.

UPDATE: This was NOT fully adopted. Private market investments are now RECOMMENDED to have an external valuation at least every 12 months; however, real estate investments included in a real estate open-end fund are still required to have external valuations at least every 12 months. Real estate investments that are not included in real estate open-end funds are required to have an external valuation at least every 12 months unless the client agrees to a less frequent external valuation (minimum of every 36 months) OR, instead of the external valuation, the real estate investment can be subject to an annual financial statement audit.

Carve-outs

That’s right, carve-outs are back! Firms that spent a lot of time and money revising their composites when carve-outs were disallowed in 2010 may not be happy to hear this, but this is likely good news for wealth management firms with balanced accounts that want to market asset class specific strategies. It is not yet clear whether carve-outs can be built historically covering the period they were disallowed (2010 – 2020), but this was discussed at the GIPS conference and we expect it to be clarified.

UPDATE: This change was adopted as part of the 2020 GIPS standards and updates can be made for historical periods once the firm has adopted the 2020 GIPS standards.

Portability

Under the current Standards, GIPS requires firms to link prior track records to ongoing performance if all of the portability requirements are met. GIPS 2020 proposes to make the linking of historical performance optional.

UPDATE: This change was adopted as part of the 2020 GIPS standards.

Advisory-Only Assets

Firms are required to report total firm assets that include the assets of both discretionary and non-discretionary portfolios. GIPS 2020 clarifies that advisory-only assets cannot be presented as a part of total firm assets, but may be presented separately. With the growth of Unified Managed Account (UMA) platforms, many firms’ assets are shifting to the “advisory-only” category. Although presented separately from total firm assets, being able to present these advisory-only assets will allow firms with a large UMA business to demonstrate the amount of assets invested in their models.

UPDATE: This change was adopted as part of the 2020 GIPS standards.

Deadline to Update GIPS Presentations

GIPS Composite Reports (formerly known as Compliant Presentations) will need to be updated with the latest annual statistics within 6 months after the annual period ends. This won’t be an issue for most firms, but firms who prefer to have their verification complete prior to updating their presentations may struggle to get this updated in time.

UPDATE: A deadline to update GIPS Reports was adopted as part of the 2020 GIPS standards; however, a more reasonable 12 months after the annual period ends was set instead of the proposed 6 month deadline.

Sunset Provisions for Select Disclosures

GIPS 2020 will allow some disclosures, such as disclosures of benchmark changes or material events to be removed when they are no longer relevant for current prospects.

UPDATE: This change was adopted as part of the 2020 GIPS standards.

Additional Statistic in GIPS Presentations

GIPS 2020 will require a 3-year annualized return to be presented for both the composite and benchmark. GIPS already requires the 3-year annualized ex post standard deviation to be presented for the composite and benchmark, so this provides the return that matches the periods included in the standard deviation calculation.

UPDATE: This change was NOT adopted as a requirement of the 2020 GIPS standards, but was instead adopted as a recommendation.

Estimated Transaction Costs

Previously, the use of estimated transaction costs was prohibited. Because of this, many wrap managers, or managers of accounts with asset-based transaction fees that do not reduce gross-of-fee returns, are required to present their gross-of-fee returns as supplemental information. As long as these firms are able to estimate the transaction costs and support that the estimated costs result in gross-of-fee performance that is lower than when using actual transaction costs, these managers will be able to present gross-of-fee returns without the supplemental disclosures under GIPS 2020.

UPDATE: This change was adopted as part of the 2020 GIPS standards; however, the requirement for calculating returns that are more conservative when using estimated transaction costs was removed because it may be too difficult to prove. It was clarified that estimated transaction costs may only be used when actual transaction costs are unknown. Guidance on how to determine estimated transaction costs will be included in the Handbook, which is expected to be published by the end of 2019.

Revised Advertising Guidelines

GIPS 2020 takes a broader approach to the Advertising Guidelines to include advertisements to Pooled Fund Investors and Asset Owners rather than only for composites intended for Segregated Account Investors. Additionally, the requirements were loosened by changing some of the previously required disclosures to recommendations and by increasing the options for performance periods presented.

UPDATE: This change was adopted as part of the 2020 GIPS standards.

What action should be taken now?

UPDATE: The 2020 GIPS standards are now published. Please see our latest blog “2020 GIPS Standards: Prepare for the Changes“ to help your firm determine what steps you need to take to comply with the 2020 edition of the GIPS Standards.

The changes listed above are a sample of the most significant changes. If you are concerned about the changes, I would strongly encourage you to review the full exposure draft and provide comments to the GIPS Executive Committee. Read the full Exposure draft and provide any comments to the following email: standards@cfainstitute.org. Comments must be submitted by December 31, 2018.

Please note that the exposure draft contains 47 specific questions that the GIPS Executive Committee would like feedback on prior to finalizing the changes. You can provide comments on as many or as few of those questions as you like. Additionally, you can feel free to provide comments on any aspect of the Standards even if not related to one of the questions posed. Keep in mind that providing positive responses to what you do like is as important as providing critical feedback. If only critical feedback is provided, there is the risk that changes could be made based on the critical responses received that actually represent a minority of the stakeholders’ opinions since they did not hear the positive support for the change.

Questions?

If you have questions about GIPS 2020 or the Standards in general, we would love to talk to you. Longs Peak’s professionals have extensive experience helping firms become GIPS compliant as well as helping firms maintain their compliance with GIPS on an ongoing basis. Please feel free to email Sean Gilligan directly at sean@longspeakadvisory.com.

Today, September 3, 2018, Longs Peak turns 3 years old! Over the last 3 years we have provided investment performance and GIPS consulting services to over 70 investment firms and we are proud that, for many of these firms, we helped them claim compliance with the GIPS standards for the first time.

To celebrate this occasion, instead of writing a technical blog about performance and GIPS, I’d like to share what this date means to me each year.

September 3^rd was not an arbitrary date to launch our firm. This date is significant to me because on September 3^rd 2003 I had my first open heart surgery to repair an aortic aneurysm and to replace my aortic valve with a valve from a pig. Exactly ten years later, on September 3^rd 2013, I had a second open heart surgery to replace my pig valve with a valve from a cow because my pig valve had torn.

Going through these surgeries and the recovery periods that followed was not easy, but I made a conscious decision to embrace being part farm animal and focus on the positive. These experiences motivated me to live my life to its fullest potential. This means something different to everyone, but for me, this meant taking chances to ensure I didn’t look back on my life wishing I’d had the courage to do something I was too scared to try. One of the biggest chances I took was leaving a great job to start Longs Peak. This was one of the scariest decisions I’ve ever made, but it has been one of the most rewarding adventures of my life, thanks to our wonderful clients and amazing team.

Over the years, this mentality has pushed to make decisions that help me truly experience life outside of work as well. Specifically, on or around September 3^rd each year, I celebrate my life and health by doing something I would not have been able to do if it weren’t for the success of these surgeries. In previous years I have run a marathon, completed long hikes, and climbed 14ers (mountains in Colorado above 14,000 feet), but this year I am taking it to a new level!

With this year being both the 5^th and 15^th anniversaries of my two surgeries, I was looking for a big physical challenge as well as a way to encourage the people around me to live long, healthy, and satisfying lives. This year, I have decided to climb Mount Kilimanjaro as a fundraiser for the American Heart Association, which I will do during the second half of this month.

The American Heart Association’s mission is to be a relentless force for a world of longer, healthier lives. Without the hard work of organizations like this, the idea of putting parts of farm animals into people would sound ridiculous. Actually, it still does sound ridiculous, but it works, and it gives people like me the opportunity to live full and complete lives.

I would love to have your support in this adventure. If you are interested in contributing to the fundraiser, donations of any amount are greatly appreciated and can be made through the link below. Please note that as my contribution to this cause I will personally match all donations up to $2,500.

Link to fundraiser page: Gilly Does Kili

Most GIPS compliant firms are aware of the requirement to provide their compliant presentations to prospective clients, but it can be a little confusing how to reference GIPS in other materials.

It is important to remember that you should never just casually reference your firm’s GIPS compliance without considering what disclosures are required to accompany that claim of compliance. Specifically, if you are creating an advertisement (any material meant for a broad audience, generally designed to attract people to become prospective clients of your firm), you have the following three options:

• Don’t mention GIPS at all.
• Mention GIPS and include a compliant presentation with all required GIPS disclosures.
• Mention GIPS and follow the more abbreviated requirements of the GIPS Advertising Guidelines.

Why do some GIPS Compliant firms avoid mentioning GIPS?

One reason firms choose not to mention GIPS in an advertisement is due to space constraints or the logistics of fitting the required disclosures without looking awkward. For example, firms often try to keep factsheets to one page. If including the claim of GIPS compliance and related disclosures would push the presentation to a second page then the firm may elect not to mention GIPS.

Unfortunately, another common reason GIPS compliant firms choose not to mention GIPS in advertisements is out of fear of doing it wrong. After all the hard work you put in to become GIPS compliant, you should definitely be able to reference GIPS in your advertisements without fear! The information provided below explains how you can confidently make reference to your firm’s GIPS compliance in advertisements.

The Two Options When Mentioning GIPS

Option 1: Include a Compliant Presentation

Compliant presentations include all statistics and disclosures for a composite that are required to be provided to your firm’s prospective clients. While this document is most often used in a one-on-one setting with prospective clients, it can be attached to advertisements that mention GIPS as well.

In some cases, it can be easier to attach the compliant presentation rather than trying to incorporate the advertising disclosures directly into the advertisement. For example, if emailing a newsletter (considered a type of advertisement) and your firm wants to mention GIPS in the letter, you could include the compliant presentation as an attachment to the email rather than trying to fit the advertising disclosures into the newsletter itself. Making a reference to the attached GIPS compliant presentation may be cleaner than adding disclosures directly into the newsletter itself.

Also, many firms looking to add a reference to their GIPS compliance on their website (also considered a type of advertisement) will simply add a link to their compliant presentations rather than putting the advertising disclosures directly on the website. This way, you can simply add a link to the detailed information for each composite rather than adding disclosures referencing who to contact to receive a copy of the disclosures, etc., which is required by the GIPS Advertising Guidelines.

Option 2: Follow the GIPS Advertising Guidelines

Following the GIPS Advertising Guidelines allows a firm to mention GIPS in an advertisement with a more abbreviated set of disclosures than what is required for a compliant presentation. This is the most common option firms follow when they want to mention GIPS in a print ad or press release where attaching a compliant presentation would not be feasible.

The disclosures required by the GIPS Advertising Guidelines are different depending on whether performance is included in the advertisement or not. If you elect to follow the GIPS Advertising Guidelines, we recommend that you use our Required Disclosures for GIPS Compliant Advertisements checklist. This list can greatly assist in helping your firm confidently reference GIPS compliance in all of your advertisements.

Want to learn more?

If you have questions about the GIPS standards, we would be love to talk to you. Longs Peak’s professionals have extensive experience helping firms become GIPS compliant as well as helping firms maintain their compliance with GIPS on an ongoing basis. Please contact us or email Sean Gilligan directly at sean@longspeakadvisory.com.

Firms that are GIPS compliant are required to provide all prospective clients with a GIPS compliant presentation. Typically, each composite has its own separate one-page sheet that includes all the statistics and disclosures required for that composite. This one-page sheet can be attached as an appendix to your firm’s pitchbooks and other marketing materials to properly represent your firm to the public as a GIPS compliant firm.

Not all compliant presentations are the same. Your firm’s required statistics and disclosures will depend on your firm’s strategies and policies. In this article, we discuss the required statistics and disclosures applicable to most GIPS compliant firms. In addition, we provide information on common issues firms face when creating compliant presentations and what you might be able to do to avoid them.

Required GIPS Statistics

Although additional statistics may be required, the following are the most common statistics that GIPS compliant firms are required to present in their compliant presentations:

• Annual composite time-weighted returns (gross and/or net) – GIPS recommends the use of gross-of-fee returns; however, at least in the United States, it is most common to include both gross and net-of-fee returns. Net returns can be based on actual management fees or a model fee. As discussed in a previous post titled “Are fee-related administrative issues causing errors in your investment performance?” using a model fee instead of actual fees may be necessary when you have clients that pay fees from an outside source (e.g., by check or from another account your firm manages for them).
• Annual benchmark returns – GIPS requires the use of a benchmark unless you are able to disclose a reason why no meaningful benchmark is available. Even if your strategy is benchmark agnostic, most firms choose to include the most relevant benchmark available and then disclose any material differences between the benchmark and the strategy.
• Number of portfolios in the composite as of each year-end – This is simply the number of portfolios that are included in the composite as of 31 December each year.
• Total assets in the composite as of each year-end – This is simply the sum of the composite assets as of 31 December each year.
• Total assets of the GIPS firm as of each year-end – This is the sum of all discretionary and non-discretionary portfolio assets that are included in the firm definition as of 31 December each year.
• A measure of internal dispersion for each annual period – Internal dispersion is a measure used to give the user of the performance report an indication as to how tightly the strategy is managed. In other words, if you are reporting that the composite return was 10% for the most recent annual period, a low internal dispersion figure will tell the user that most portfolios in the composite returned approximately 10%. High dispersion would indicate that the portfolios in the composite had a more diverse set of returns (e.g., perhaps some returned 5% while others returned 15%). Typically, firms use standard deviation to present this, which can either be calculated on an equal-weighted or asset-weighted basis.
• Three-year annualized ex-post standard deviation of both the composite and the benchmark based on monthly returns – This is a measure of risk. The standard deviation of the composite’s monthly returns and the benchmark’s monthly returns provides the user of the performance report an idea of the level of risk taken compared to the benchmark. Ideally, you want higher annual returns and lower annualized standard deviation compared to the composite’s benchmark. That would indicate that you were able to outperform while taking less risk. For composites where a different measure of risk would be more meaningful than standard deviation, firms may present an additional risk measure with an explanation as to why that measure is more relevant, but the annualized standard deviation must still be included.

Other statistics may also be required if, for example, your firm manages non-fee-paying or bundled-fee accounts. Firms with these types of accounts must show the percentage of the composite they represent as of each year-end. Firms with private equity or real estate composites also require different statistics which can be found in the Real Estate and Private Equity provisions of the GIPS Standards.

Required Disclosures

When reviewing compliant presentations before distribution, many firms focus purely on the statistics presented to ensure material errors do not exist. This is often done without realizing that missing or incorrect disclosures can also be considered a material error. Thus, you’ll want to make sure your review process incorporates an evaluation of both.

The disclosures that must be included in a GIPS compliant presentation will differ by firm and by composite. Rather than listing all of them here, we have compiled a checklist of required GIPS disclosures which can be used as part of your firm’s marketing material review process. This checklist can be used to help you incorporate the proper disclosures for each compliant presentation prior to approving them for external use.

When reviewing the disclosures included in your firm’s GIPS compliant presentations, it is important to ensure:

1. No required disclosures are missing.
2. The disclosures are consistent with the policies documented in your GIPS Policies and Procedures document (“GIPS P&P”), including any recent changes to policies. For example, if a minimum asset level is changed for a composite, it is important to ensure that this change is consistently:
   1. documented in your firm’s GIPS P&P,
   2. implemented in the actual composite construction, and
   3. disclosed in the GIPS compliant presentation.
3. Any disclosures (such as the claim of compliance) that are required to be written word-for-word as stated in the standards, are not modified in any way.

Common Issues

Firms that do not have composite maintenance software or an external GIPS consultant to create their GIPS compliant presentations often create them manually. When creating and updating compliant presentations yourself, it is important to avoid theses common mistakes:

1. Don’t double count assets. For example, if the same portfolio is included in more than one composite you will not be able to sum your composite assets to get to your total GIPS firm assets. Additionally, if you manage a fund and then some of the separate accounts you manage invest in that fund as part of their portfolio, you need to ensure you do not count those assets both as part of the fund and again as part of the separate accounts. It is also important to ensure that only actual accounts are included. Models and anything that is considered “advisory-only” should be excluded from your calculation.
2. Ensure that the number of portfolios reported is the total number of portfolios included in the composite as of 31 December of that year. Since internal dispersion is calculated based on only the portfolios that were in the composite for the full year, some firms make the mistake of reporting their number of portfolios as just the number of portfolios that were included for the full year. This is not correct as this statistic is intended to be the total number of portfolios in the composite as of each year-end.
3. When partial-year performance is presented, it is important to:
   1. Clearly label the period for which performance is presented.
   2. Match the benchmark period to the period presented for the composite.
4. Keep your presentations up-to-date. This means:
   1. Updating presentations with corrected statistics if corrections are made to the composite’s data. For example, firms may make updates to transactions for reconciliation purposes, such as backdating dividends. If this results in a change to composite-level statistics, then the compliant presentations must be updated accordingly. It is important to consistently follow your firm’s GIPS error correction policy. Typically, immaterial changes to the statistics are updated for future use even if the changes are not large enough to trigger redistribution of the presentation.
   2. Updating presentations with the most recent year’s statistics as soon as they become available. It is not necessary to wait for the verification to be complete before adding and presenting updated statistics. For example, if your annual GIPS verification for calendar year 2017 will not be complete until mid-2018, you do not need to wait until the verification is complete to present the 2017 statistics in your compliant presentation. You just cannot update the date your firm is verified through until the verification report is issued (i.e., you can present unverified statistics for the 2017 period, but the date range of your verification will still be disclosed as ending 31 December 2016). This lets the user of your compliant presentation have the latest statistics while letting them know that the verification for the latest period is pending.
5. Ensure there are no typos if you are manually entering the statistics into a table. Typos can easily cause material errors that would trigger the need for redistribution of the presentation with disclosure of the error. Establishing a simple review process can help your firm avoid this headache.
6. Make sure the information for each composite is entered into the correct compliant presentation (i.e., ensure you do not enter the statistics for Composite A into the presentation for Composite B). Seems obvious, but you’d be surprise how often this mistake is made. Again, a reliable review process can help your firm avoid these mistakes.

Want to Learn More?

If you have any questions about creating compliant presentations or any GIPS statistics or disclosures, we would love to help. Longs Peak’s professionals have extensive experience helping firms become GIPS compliant as well as helping them maintain compliance with the GIPS Standards on an ongoing basis. Contact us to learn how we can help.

GIPS compliant firms are required to calculate and present composite performance, rather than presenting the performance of a model or single representative account. The purpose of this is to ensure investment managers are presenting an accurate representation of their ability to implement a strategy, rather than “cherry-picking” their best performing portfolio. As discussed in our previous 2-part blog post, about how to create a GIPS Policies & Procedures Document, composites must be defined based on the strategies your firm manages. Once your composites are defined and composite rules established, you are then ready to construct your composites.

https://www.youtube.com/watch?v=0RqBP0i_KF8&feature=emb_logo

Organize Portfolios by Strategy

A composite is an aggregation of portfolios with similar objectives. The first step in constructing composites is to group all of the portfolios your firm manages by strategy, which will later be refined by applying composite rules. Strategies can be as broadly or narrowly defined as you like as long as the resulting performance statistics are meaningful. If you are not sure how to define your firm’s strategies, you should consult with a GIPS expert to ensure the definitions maximize the marketing opportunities available to your firm. Most importantly, you should ensure that they are:

1. Representative of how your strategies are managed and how you intend to market your firm’s offerings.
2. Broad enough to have sufficient assets that may be required to attract certain institutional investors.
3. Narrow enough that the dispersion is low and the performance results are meaningful.
4. Easily comparable to the strategies marketed by your firm’s closest competitors.

When grouping your portfolios into strategies, you must consider both the portfolio’s current mandate as well as historical changes in your clients’ investment policy statements. If a portfolio’s strategy has changed since inception, you must check that it is grouped under the correct strategy both before and after the change.

Apply Composite Rules

Once portfolios are grouped by the strategy they followed for each period, you can then apply your firm’s composite rules established in your GIPS Policies and Procedures document (“GIPS P&P”) to create each strategy’s corresponding composite. For example, if you have a U.S. Large Cap Growth strategy, you can start by evaluating all of the portfolios that follow this strategy’s definition. If the portfolio meets your firm’s GIPS definition of discretion and does not break any other composite rule (such as minimum asset level), the portfolio can be added to your U.S. Large Cap Growth composite.

The timing of the portfolio’s inclusion in the composite will be based on the inclusion policy set in your firm’s GIPS P&P (e.g., the first full month after the portfolio is funded or the first full month after the portfolio is at least X% invested). The portfolio will then remain in the composite until discretion to implement this strategy is lost, at which point the portfolio will be excluded from the composite based on the exclusion policy set in your firm’s GIPS P&P (e.g., the end of the last full month before discretion was lost).

Discretion to implement this strategy can be lost one of the following ways:

1. The client adds a restriction to the portfolio causing it to no longer meet your firm’s definition of discretion – The portfolio becomes non-discretionary until the restriction is lifted or until the restriction no longer interferes with the implementation of the strategy.
2. The client notifies your firm that they will be terminating your management of the portfolio – The portfolio is closing and is considered non-discretionary until the assets transfer out.
3. The client requests a change to a different strategy – The portfolio is temporarily non-discretionary as it is rebalanced to fit the new strategy, at which point it will enter the new strategy’s composite based on its inclusion policy documented in your firm’s GIPS P&P.
4. The client makes a deposit or withdrawal of cash or securities that exceeds the composite’s defined “significant cash flow” threshold – The portfolio is temporarily non-discretionary as trading takes place to facilitate the client-requested cash flow and the portfolio will be re-included in the composite based on the timing documented in your firm’s significant cash flow policy.
5. The portfolio’s market value drops below the composite’s documented minimum asset level – The portfolio becomes non-discretionary until the market value goes back above the composite’s minimum asset level, at which point the portfolio would be considered discretionary again and would be re-included in the composite based on the timing documented in your composite’s minimum asset level policy.

It is important to note that the first four of the five scenarios listed above are driven by client requests and the fifth is based on a predetermined policy. The removal of a portfolio from a composite cannot be based on changes made to a portfolio that are driven by the portfolio manager. If a portfolio manager makes a tactical shift in the strategy, such as holding higher cash because of current market conditions, this would be considered an evolution of the strategy definition rather than a reason to remove an account from the composite.

Conduct Tests Before Finalizing Composites

The process of reviewing portfolios to ensure they are placed in the correct composite for the right time period can be difficult. Many firms rely on GIPS consultants or composite software to help test their composites to identify portfolios that break composite rules or exhibit outlier performance (indicating that a portfolio may not belong in the composite). Being proactive about composite testing allows you to make corrections before finalizing composite results for distribution or verification.

Best practice is to address these issues when building the composites rather than waiting for issues to be caught during the verification process. Often, when issues come up during verification, it leads to an increase in the verification testing sample size, resulting in more work and potentially more cost to complete the verification.

Calculate Composite Statistics

Once your composite membership is finalized, you can then calculate composite statistics. Specifically, you will need to calculate annual composite performance, a measure of internal dispersion, and three-year annualized ex-post standard deviation. The calculation methodology used must be consistent with the methodology described in your firm’s GIPS P&P.

We will discuss each of these statistical measures as well as well as the other figures and disclosures that must be included in a GIPS compliant presentation in the final part of this blog series “How to Create GIPS Compliant Presentations.” Please subscribe to our blog or follow us on social media to ensure you don’t miss the conclusion and to receive future GIPS and performance-related educational updates.

Want to Learn More?

If you have any questions about the GIPS Standards, we would love to help.  Longs Peak’s professionals have extensive experience helping firms become GIPS compliant as well as helping them maintain compliance with the GIPS Standards on an ongoing basis.

The GIPS Executive Committee (“EC”) is preparing for a full re-write of the GIPS standards, which they are referring to as GIPS 20/20. It is referred to as GIPS 20/20 as it is a “vision” for the future of the standards and because it also is intended to be rolled out in the year 2020.

The EC has never put out a consultation paper of this kind before; typically the only opportunity to comment is after new guidance is already drafted. This is your opportunity to help shape the future of the standards by submitting your comments in response to the questions they pose in the consultation paper. To provide feedback, please send your comments to standards@cfainstitute.org by 16 July 2017.

The full GIPS 20/20 Consultation Paper is available on the GIPS Standards website. The areas of focus include:

• The structure of the standards to ensure they are applicable to all types of investment managers as well as to asset owners
• Specific treatment of pooled funds, to build on the Guidance Statement on Broadly Distributed Pooled Funds currently in place
• Adjustments to the way asset-class specific guidance is structured in the standards (e.g., guidance specific to private equity and real estate)
• Expanded use of internal rates of return (IRR) where appropriate
• The frequency at which portfolios are required to be valued
• Providing compliant presentations to existing clients and pooled fund investors
• Options for reporting “advisory-only” assets (e.g., UMA) that do not currently fit within a firm’s assets under management (AUM)
• The inclusion of non-fee paying portfolios in composites
• References to the firm’s claim of GIPS compliance
• Timeliness and frequency for updating compliant presentations
• The use of estimated trading expenses
• Whether any required statistics or disclosures can be removed as well as if any statistics or disclosures not currently required should be added

Whether you agree or disagree with the potential changes discussed, the EC greatly appreciates any feedback provided. If you only have an opinion on some of the topics, it is okay to respond to the portions you wish. Your response does not need to be formal and could even be a simple email.

We are in the process of composing our comments and strongly encourage you to do the same. If there are any aspects of the consultation paper you do not understand, feel free to contact us and we can help give you context or clarify the concerns involved.

Calculation Methodology, Books & Records, Composite Definitions & Rules, and Error Correction Policies

As discussed in Part 1 of this two part series, GIPS compliant firms are required to document how they comply with the GIPS requirements as well as any recommendations that the firm chooses to follow. This document acts as the firm’s internal representation of their GIPS compliance, and is intended to state the firm’s policies and describe the procedures the firm follows to maintain its compliance.

In Part 1 of this two part series we covered Firm Definition and Definition of Discretion. Now, in Part 2 we will cover calculation methodology, books and records, composite definitions and rules, as well as error correction policies.

https://www.youtube.com/watch?v=UhaTy-4c-EM&feature=emb_logo

Calculation Methodology

While GIPS provides a framework for how to calculate performance, firms may have different methods for handling external cash flows, asset-weighting portfolios, calculating dispersion, etc. The specifics of the methods used must be documented in the firm’s GIPS P&P. This section is typically broken down to separately discuss portfolio-level calculation methodology and composite-level calculation methodology.

The main consideration when establishing your firm’s portfolio-level methodology is the treatment of external cash flows. Since the start of 2010, GIPS requires firms to revalue for all “large” cash flows. It is up to your firm to define the term “large,” but it should be defined based on when your firm feels that estimation methods, such as Modified Dietz, lose their accuracy. Most portfolio accounting systems either value portfolios daily (essentially defining “large” as 0%) or value portfolios for all cash flows 10% or greater. Firms without a portfolio accounting system that are calculating their portfolio-level performance more manually (e.g., in Excel) frequently use 20%, but higher than that is less common.

With regard to composite-level performance, the most important information to document is the method used to asset-weight the portfolio returns to get the composite-level performance results. This is typically achieved through one of the following three methods:

1. Asset-weight each individual portfolio’s return for the month based on each portfolio’s beginning market value and then sum the portfolios’ weighted returns to get the composite return for the month.
2. Asset-weight each individual portfolio’s return for the month based on each portfolio’s beginning market value plus weighted cash flows and then sum the portfolios’ weighted returns to get the composite return for the month.
3. Aggregate the underlying data of all portfolios in the composite and then calculate the performance for each month as if all of the aggregated data is for one large portfolio.

This section should also include information regarding how the other required GIPS statistics are calculated, such as dispersion and 3-year annualized ex post standard deviation. Here, it is important to note whether these statistics are calculated based on gross or net-of-fee returns, whether calculated by your portfolio accounting system or outside the system, (e.g., in Excel) and the specific standard deviation formula used to do the calculation (e.g., a population or sample based formula).

Policies Regarding Books and Records

Firms must be able to support all information included in GIPS compliant presentations as well as support that their client assets are real. This section of your GIPS P&P can outline the types of records that are maintained and in what format/location they are stored. Specifically, firms typically outline the types of documents they have (e.g., custodial statements, records maintained within a portfolio accounting system, printed records from a former portfolio accounting system such as holdings reports, transaction summaries, etc.). In this section, it is also important to mention whether files are hardcopy or electronic, whether they are maintained onsite or offsite, and if there is a limit to the amount of time they are saved.

Composite Definitions and Rules

irms must create policies to ensure that portfolios are placed in the appropriate composite for the correct time period. The timing of portfolio movement in or out of composites must be based on objective criteria that is outlined in this section of the firm’s GIPS P&P. For example, firms typically either set a policy based on the amount of time passed since discretion was granted or based on when the portfolio becomes “fully invested” – which must be clearly defined.

For example, if based on time, the policy may be written as, “portfolios are included in the composite at the start of the first full month under management.” If based on when the portfolio becomes fully invested, the policy may be written to state, “portfolios are included in the composite at the start of the first full month after the portfolio is at least 90% invested in line with the strategy.” The percentage set can be whatever your firm feels is appropriate, but you want to establish a clear threshold that can be followed. Simply stating “fully invested” is subjective and difficult to follow consistently.

Other rules can also be documented in this section such as minimum asset levels and significant cash flow thresholds, to keep portfolios out of composites during periods where the intended strategy cannot be fully implemented. Minimum asset levels set for GIPS composite purposes are different than minimums your firm may set for marketing purposes. While your firm can state any marketing minimum you wish based on the size portfolios you hope to attract, the minimum set for composite inclusion must be based on the minimum amount needed to fully implement that strategy. For example, even if your firm states that your strategy has a $1M minimum, portfolios accepted below this threshold must still be included in the composite if they can be managed the same as the portfolios over $1M. In this example, if you determine that below $500k you can no longer diversify the same way as you do for your larger portfolios, then $500k would be an appropriate minimum to set for composite inclusion purposes.

A significant cash flow policy can be established if your firm is concerned with very large cash flows moving in or out of a portfolio. Often these cash flows affect the portfolio’s performance and could distort the composite’s statistics. Firms wishing to implement a significant cash flow policy establish a threshold for the size of a cash flow (typically based on the percentage of the portfolio’s beginning of month market value) that would trigger the temporary removal of the portfolio from the composite while trading takes place to accommodate the cash flow.

This “significant” cash flow threshold is different than the “large” cash flow threshold discussed in the calculation methodology section. While the “large” cash flow threshold is set to improve the mathematical accuracy of the performance calculation, the “significant” cash flow threshold is based on the size of a cash flow that disrupts the actual management of the portfolio. Significant cash flows often lead to distorted performance figures that were out of the portfolio manager’s control in terms of timing or amount.

Error Correction Policies

Firms must create materiality thresholds that pre-determine the action required if errors occur in a compliant presentation. This section should include thresholds for all statistics as well as criteria for determining when errors in disclosures are material. Defining materiality thresholds can be difficult, but CFA Institute, in conjunction with the United States Investment Performance Committee (USIPC), conducted a GIPS error correction survey seeking information regarding the typical materiality thresholds used by GIPS compliant firms. We recommend reviewing the Executive Summary of this survey’s results to get an idea of the thresholds that have been set by your peers.

Typically, thresholds are set that define the level when an error becomes a material error. Anything above the threshold would require the firm to redistribute an amended GIPS compliant presentation to any prospective client or clients that relied on the erroneous presentation. This amended GIPS compliant presentation would also need to include a disclosure that explains the correction. Anything below the materiality threshold will only trigger a correction for future distributions, but no disclosure or redistribution of previously circulated presentations.

Updates for GIPS 2020

The GIPS standards were updated in 2020. Check out our post How to Update Your GIPS P&P for GIPS 2020 to make sure your P&Ps are consistent with these changes.

Want to Learn More?

If you have any questions about the GIPS Standards, we would love to help.  Longs Peak’s professionals have extensive experience helping firms become GIPS compliant as well as helping them maintain compliance with the GIPS Standards on an ongoing basis.