Around the Peak.

Your firm works hard to comply with the Global Investment Performance Standards (GIPS®) and likely expects the benefits of GIPS to far outweigh any burden associated with maintaining compliance. Most of the policies and procedures your firm set when first becoming compliant will never need to change; however, as both the standards and your firm evolves, it is beneficial to conduct a high-level review of your GIPS compliance each year. This high-level review will help ensure that you continually refine your processes and policies to maximize the benefits of claiming compliance with GIPS year after year.

This year, conducting a review of your firm’s GIPS compliance is especially important because of the 2020 Edition of the GIPS Standards that was published in mid-2019. For information specific to the 2020 changes, please check out 2020 GIPS Standards: Prepare for the Changes.

Even without the release of a new edition of the standards, each year you should conduct a review. In the review, you should first make sure you have the right people involved. One person or department may be responsible for managing the day-to-day tasks that maintain your GIPS compliance; however, high-level oversight from a larger group should take place to help ensure that any decisions made or policies set will integrate well with your firm’s other strategic initiatives. This larger group, often called a GIPS Committee, typically consists of representatives from compliance, marketing, portfolio management, operations/performance, and senior management.

Not everyone on the committee needs to be an expert in the GIPS standards. In fact, many will not be. What they will need is to be available to share their opinions and represent their department’s interests when establishing or changing key policies for your firm. Your GIPS compliance expert/manager can set the agenda for your meeting and can provide any background on the requirements that will be part of the discussion. If you do not have a GIPS expert internally, or need independent advice about your policies and procedures, a GIPS consultant can be hired to help.

High-Level GIPS Topics to Consider Annually

Once you select the right group to represent each major area of your firm, the following high-level questions can help determine if any action is necessary to improve your GIPS compliance this year:

• Have there been any changes to the GIPS standards?
• Have there been any material changes to your firm or strategies?
• Do your composites meaningfully represent your strategies or should their structure and descriptions be reconsidered?
• Are the materiality thresholds stated in your error correction policy appropriate for the type of strategies you manage and are they consistent with the thresholds set by similar firms?
• Are you satisfied with the service received from your GIPS verifier for the fee that is paid?
• Is there any due diligence you need to conduct on your verification firm?

Changes to the GIPS Standards

It is important to consider whether there have been any changes to the GIPS standards since last year that would require your firm to take action. For example, if a new requirement is adopted, you should consider if any changes to your firm’s policies and procedures or GIPS Reports are needed.

Keep in mind that GIPS compliant firms must comply with all requirements of the GIPS standards including any updates that may be published in the form of Guidance Statements, Questions & Answers (Q&As), or other written interpretations.

If your firm is verified or works with a GIPS consultant, these GIPS experts are likely keeping you informed of any changes to the standards. The best way to check for changes yourself is to visit the “Standards & Guidance” section of www.gipsstandards.org. Specifically, you should check the “GIPS Q&A Database” where you can enter the effective date range of the previous year to see every Q&A published during this period. You should also check the “Guidance Statements” section. The guidance statements are organized by year published, so it is easy to see when new statements are added.

With the new 2020 Edition of the GIPS Standards, a review of the changes to determine how they affect your firm is especially important this year. These changes must be fully adopted before presenting returns in your GIPS reports for periods ending on 31 December 2020 or later.

Changes to Your Firm or Strategies

Similar to changes in the standards, it is important to also consider whether any changes to your firm or its strategies would require you to take action. Examples include, material changes in the way a strategy is managed, a new strategy that was launched, an existing strategy that closed, mergers or acquisitions, or anything else that would be considered a material event for your firm.

Even if no changes were made this year, you should still read your entire policies and procedures document at least annually to make sure it adequately and accurately describes the actual practices followed by your firm. Regulators, such as the Securities and Exchange Commission (SEC), commonly review firms’ policies and procedures to ensure 1) that the document includes actual procedures and is not simply a list of policies and 2) that the stated procedures truly represent the procedures followed by the firm. Many firms have created their policies and procedures document based on template language, so tweaks may be necessary to customize the document for your firm.

Meaningful Composite Structure

The section of your GIPS policies and procedures requiring the most frequent adjustment is your firm’s list of composite descriptions, as you must make changes each time a new composite is added or if a composite closes. However, even without adding new strategies or closing older strategies, the list of composite descriptions should be reviewed at least annually to ensure they are defined in a manner that best represents the strategies as you manage them today.

Since your firm’s prospects will compare your composite results to those of similar firms, it is important that your composites provide a meaningful representation of your strategies and are easily comparable to similar composites managed by your competitors. If a review of your current list of composite descriptions leads you to realize that your strategies are defined too broadly, too narrowly, or in a way that no longer accurately describes the strategy, changes can be made (with disclosure).

Keep in mind that changes should not be made frequently and cannot be made for the purpose of making your performance appear better. Changing your composite structure for the purpose of improving your performance results, as opposed to improving the composite’s representation of your strategy, would be considered “cherry picking.”

Two examples of cases that may require a change in your composites include:

1. A strategy has evolved and certain aspects of the way the strategy was managed and defined in the past are different from today. This can be addressed by redefining the composite. Redefining the composite requires you to disclose the date and description of the change. This disclosure will help prospects understand how the strategy was managed for each time period presented and when the shift in strategy took place. Changes like this should be made to your composite descriptions at the time of the change, but an annual review can help you address any items that may have been overlooked when the change occurred.
2. A composite is defined broadly to include all large capitalization accounts. Within this large capitalization composite, there are accounts with a growth focus and others with a value focus. If your closest competitors are separately presenting large capitalization growth and large capitalization value composites, your broadly defined large capitalization composite may be difficult for prospects to meaningfully compare to your competitors. To address this, you can create new, more narrowly defined composites to separate the accounts with the growth and value mandates. In this case, the full history will be separated and the composite creation date disclosed for these new composites will be the date you make the change. Note that this will demonstrate to prospective clients that you had the benefit of hindsight when determining the definition.

Materiality Thresholds Stated in Your Error Correction Policy

Another section of your firm’s GIPS policies and procedures that should be reviewed in detail is your error correction policy. Your error correction policy includes thresholds that pre-determine which errors (of those that may occur in your GIPS Reports) are considered material versus those deemed immaterial. These thresholds cannot be changed upon finding an error; however, they can be updated prospectively if you feel a change would improve your policy.

Many firms had a difficult time setting these thresholds when this requirement first went into effect back at the start of 2011. Now that much more information is available to help you determine these thresholds, such as the GIPS Error Correction Survey, you may want to revisit your policy to ensure it is adequate.

Setting and approving materiality thresholds that determine material versus immaterial errors is a task best suited for your firm’s GIPS committee rather than your GIPS department or manager. The reason for this is that opinions of what constitutes a material error will vary from one department to another. Your committee can help find a balance between those with a more conservative approach and those with a more aggressive approach to ensure the thresholds selected are appropriate.

GIPS Verifier Selection and Due Diligence

If your firm is verified, it is important to periodically evaluate whether you are satisfied with the quality of the service received for the fees paid. You may also want to consider whether you need to conduct any periodic due diligence on your verification firm with respect to data security or other concerns important to your firm.

With several mergers, acquisitions, and start-ups in the verification community over the last few years, you may need to do some research to ensure you are familiar with what your options are when selecting a verification firm.

All verifiers have the same general objective: to test and opine on 1) whether your firm has complied with all of the composite construction requirements of the GIPS standards and 2) whether your firm’s GIPS processes and procedures are designed to calculate and present performance in compliance with GIPS. Where they differ is in the fees charged and process followed to complete the verification.

With regard to fees, much of the difference between verifiers is based on their level of brand recognition rather than differences in the quality of their service. For example, smaller firms specialized in GIPS verification may have more experience with the intricacies of GIPS compliance than a global accounting firm; yet, a global accounting firm will likely charge a higher fee. When selecting a higher fee firm, it is important to consider whether the higher fee is offset by the benefit your firm receives when listing their brand name as your verifier in RFPs you complete.

With regard to process, the primary difference between verification firms is whether the verification testing is done onsite or remotely. There are pros and cons to both methods and it is important for your firm to consider which works best for the team that is fielding the verification document requests. The onsite approach may result in finishing the verification in a shorter period, but may be disruptive to your other responsibilities while the verification team is in your office. The remote approach may be less disruptive to your other responsibilities, but likely will take longer to complete and may be less efficient as documents are exchanged back and forth over an extended period of time. Another difference is how the engagement team is structured, whether you can expect to work with the same team each year, and how much experience your main contact has.

Regardless of whether the verification is conducted onsite or remotely, be sure to ask any verifier how your proprietary information and confidential client data is protected. If the work is done remotely, how are sensitive documents transferred between your firm and the verifier (e.g., is it through email or a secure portal) and once received by the verifier, do they have strong controls in place to ensure your data is not breached.

If the work is done onsite, it is important to ask what documents (or copies of documents), if any, the verifier will be taking with them when they leave, and whether these documents are saved in a secure manner. Documents saved locally on a laptop are at higher risk of being compromised.

Questions?

For more information on how to maximize the benefits your firm receives from being GIPS compliant or for other investment performance and GIPS compliance information, contact Sean Gilligan at sean@longspeakadvisory.com.

What do Capture Ratios Explain?

Capture ratios help investors assess how a strategy holds up during different market conditions. They can be used to demonstrate how a strategy performs across different cycles of the market by quantifying how much of the market performance your strategy “captures” on the way up or on the way down.

What is the Up-Market Capture Ratio?

The Up-Market Capture Ratio evaluates a strategy's performance in up-markets. It measures how well a manager performed relative to its benchmark during rising market conditions. The ratio is calculated by dividing the average strategy returns by the average returns of the benchmark, but only including periods where the benchmark returns were positive.

Up-Market Capture Formula

How to interpret the Up-Market Capture Ratio

It is best to compare the results of both Up-Market and Down-Market Capture to 100. For Up-Market Capture, it is ideal to have a result greater than 100 because this signifies that the strategy outperformed the benchmark while the market is rising. For example, if the Up-Market Capture is 115, this shows that the strategy outperformed the benchmark by 15% during the period. This is a helpful indicator for managers that want to demonstrate that their strategy will beat the index during rising market conditions.

However, because this measure focuses on the upside, it will not give you a full picture of the strategy’s performance. A defensive strategy, focused on downside protection, may have a low up-market capture, but still be outperforming because of its low market capture on the downside. It is therefore most common to present this measure in conjunction with the Down-Market Capture Ratio, to provide a more complete picture of overall performance.

What is the Down-Market Capture Ratio?

The Down-Market Capture Ratio assesses a strategy's performance in down-markets and measures how well a manager performed relative to the index while the market is falling. Similar to Up-Market Capture, it is calculated by dividing the average strategy returns by the average returns of the benchmark, but only including periods where the benchmark returns were negative.

Down-Market Capture Formula

How to interpret the Down-Market Capture Ratio

For the Down-Market Capture Ratio, it is ideal to have a result less than 100 because this signifies that the strategy outperformed the benchmark while the market is falling. For example, if the Down-Market Capture is 90, this shows that, on average, the strategy declined only 90% as much as the benchmark did during down periods. This is a helpful indicator for managers that want to demonstrate that their strategy outperforms during market decline. Again, because this measure focuses only on the downside, it will not provide a full picture of the strategy’s performance and should be presented together with the Up-Market Capture Ratio to provide a more complete picture.

What is Total Capture Ratio?

Total Capture Ratio measures the asymmetry of returns, quantifying overall performance across different phases of the market. Total Capture Ratio is calculated by dividing the Up-Market Capture Ratio by the Down-Market Capture Ratio.

Total Capture Ratio Formula

How to interpret Total Capture Ratio

A Capture Ratio greater than one (1) indicates that the strategy outperformed the benchmark overall. For example, if the Down-Market Capture is 115, but Up-Market Capture is 130, this gives you a Total Capture Ratio of 1.13, indicating that the performance in rising markets offsets the performance during market slump. The same is true for strategies whose primary objective is to protect on the downside. Even when up-market capture is low or breaks even, if the strategy performs well in down markets, it can still outperform the market overall. For example, an up-market capture of 80 and down-market capture of 60 results in total capture of 1.33.

Why are Capture Ratios Important?

Capture ratios are used to assess whether a strategy is performing according to its investment objective. If the goal of the strategy is to outperform its benchmark, Capture ratios will help demonstrate how the strategy outperformed – whether on the up-side, down-side or overall.

Questions?

If you have questions our would like help calculating risk statistics for your strategy, contact us. Or check out other investment performance statistics we've written about, including the Sharpe Ratio, Information Ratio, and others.

CFA Institute hosted the 25th annual GIPS Conference October 26^th - 27^th 2021. Like last year’s conference, viewers tuned in virtually to hear from industry experts on a range of subjects relating to GIPS compliance and investment performance.

The hottest topics of this year’s conference were the newest developments regarding compliance with the 2020 GIPS Standards, the SEC Marketing Rule, ESG reporting, and manager selection and oversight. Below are some key takeaways from this two-day event.

Updated Resources for the 2020 GIPS Standards

The 2020 edition of the GIPS standards was issued June 2019, and compliant firms are required to make any necessary updates before presenting performance for periods including 31 December 2020 in their GIPS Reports.

This year’s conference reminded firms of these updates and discussed implementation challenges. We have shared similar information in previous articles that may help your firm implement the 2020 GIPS standards if not yet fully adopted. For more information check out our previous articles on How to Comply with the 2020 GIPS Standards, How to Update your GIPS Policies & Procedures for GIPS 2020, and How to Update your GIPS Reports for the 2020 GIPS Standards.

CFA Institute has been hard at work updating the resources on their website so that the most relevant guidance is easy to find. This has involved updating or archiving outdated and repetitive documents, with some of this content being incorporated into new Guidance Statements.

Guidance Statements are authoritative guidance on a broad topic. The Guidance Statements on Supplemental Information, Risk, and Overlay were out for comment prior to issuance of the 2020 standards. Concepts from these Guidance Statements were included in the provisions and the Handbook, covering Supplemental Information and Risk sufficiently enough for those Guidance Statements not to be issued. The Guidance Statement on Overlay Strategies is currently being finalized.

Guidance Statements updated or new in 2021 include the updated Benchmark Guidance Statement (effective 1 April 2021) and new Wrap Fee Guidance Statement (Effective 1 October 2021).

Q&As are also authoritative guidance, but on a narrower topic compared to Guidance Statements. There was a lot of re-organization done to the Q&As, with 265 Q&As being archived and 39 updated by CFA Institute. Content from many of the archived Q&As is now incorporated within the Handbook, while other Q&As are no longer applicable under the 2020 Standards.

There were several new Q&As issued addressing 2020 standards topics.

FINRA Regulatory Notice 20-21

This year’s conference also addressed FINRA Regulatory Notice 20-21, guidance from which indicates that firms presenting IRRs in private placements must calculate and present performance in accordance with the methodology outlined in the GIPS standards.

Details on the calculation and presentation requirements for IRRs, as well as additional information on this regulatory notice was outlined in a previous blog released on this topic.

The GIPS standards generally prohibit firms from making statements about calculating returns in compliance with the GIPS standards, as compliance with the GIPS standards is “all or nothing” and firms cannot partially claim compliance.

With that being said, an exemption has been made to allow firms and their agents to make a specific statement regarding the GIPS Standards only in retail communications concerning private placement offerings that are prepared in accordance with FINRA Regulatory Notice 20-21. The following statements can now be used:

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.

Databases & the GIPS Standards

Investment manager databases are a powerful tool for the collection of standardized data from investment managers, including quantitative and qualitative data on firms and their strategies.

For managers who populate databases, the importance of providing all available information and keeping the monthly and quarterly performance data up-to-date was emphasized, as not doing so increases the likelihood of being filtered out of investors’ searches.

When narrowing down managers/products, some of the main criteria investors and consultants screen by include:

• Risk/return metrics
• Assets under management
• Product-level details such as benchmarks and holdings
• ESG and Diversity & Inclusion information

Longs Peak helps many clients calculate firm and product statistics and updates them in these databases each month. Getting support in this process is a great way to keep these items updated and help your firm avoid being filtered out for dated information.

The conference speakers also emphasized that when populating databases, GIPS compliant firms should treat these communications the same as any other qualified prospective client. Firms complying with the GIPS standards are required to make their best effort to distribute a GIPS Report to all prospective clients. Firms uploading performance to databases need to think of a database as a prospective client and include their GIPS Report.

A firm’s “best effort” in providing a GIPS Report to a database should involve uploading the GIPS Report directly to the database if that option is available. Otherwise, reaching out to your firm’s database contact and providing the GIPS Report via email also checks the box for this requirement.

The 2020 GIPS standards require firms to demonstrate that they’ve met the distribution requirement, thus it’s important to save any relevant emails and document this effort in a distribution log, similar to how it is done for other prospective clients.

ESG Disclosures

Environmental, social, and governance (ESG) refers to the evaluation of a firm’s sustainability and ethical impact of an investment in a business or company. Investors are increasingly using ESG criteria to screen investment products.

Research has shown that ESG considerations can have an impact on risk and return, so paying attention to these structural, long-term trends has become a focus for many firms as well as investors. Investors want transparency around how products are put together, what they do, and how they do it.

Asset management practices vary by firm, so there tends to be an expectation gap about what ESG means to different firms and what their products do. Disclosures around ESG products have tended to be on the lighter side, focusing on ESG as a process and how these considerations are integrated into the investment process and portfolio construction rather than the outcomes of the products and how those are measured.

Managers have opted to keep these disclosures light as to give themselves the opportunity to adjust their products as the market develops. With so many different questions being asked by investors, a need has arisen for standardizing the disclosure requirements for ESG products.

The CFA Institute Global ESG Disclosure Standards for Investment Products was issued 1 November 2021. This is the first global voluntary standard for disclosing how an investment product reflects ESG matters in its objectives, investment strategy, and stewardship activities.

The Handbook, which includes an explanation of the provisions and interpretive guidance, is set to be issued on or before 1 May 2022. Assurance procedures that will enable independent assessment of ESG disclosure statements is also set to be issued by the same date.

SEC Marketing Rule

The SEC Marketing Rule went into effect 4 May 2021, and firms registered with the U.S. Securities and Exchange Commission (SEC) have until 4 November 2022 to comply. As was the case for the 2020 GIPS standards, early adopters must meet all requirements of the new rule and cannot do a partial adoption.

Under the SEC Marketing Rule, GIPS Reports are considered an advertisement rather than a one-on-one presentation because GIPS Reports typically use the same performance table for all recipients and are a standardized marketing document.

Unfortunately, requirements of the SEC Marketing Rule are not all consistent with those of the GIPS Standards. Since SEC registered firms must ensure they are meeting all regulatory requirements that go beyond what GIPS requires, there are some changes firms may need to make once the SEC Marketing Rule is adopted. For example:

Return Stream – Firms must show net-of-fee returns. Net-of-fee returns must be net of advisory fees and custody fees if the adviser is paid for the custodial services (rather than a third-party custodian).

Track Record – Firms must present the 1-, 5-, and 10-year annualized returns in advertisements. If the track record does not go back this long, the annualized since inception return must be shown, in addition to the applicable time periods listed.

1. If GIPS Reports are used as a standalone document, these statistics must be added to the GIPS Reports.
2. If the GIPS Reports are included in a pitchbook or incorporated into other marketing materials, these statistics can be shown outside of the GIPS Report.
3. Firms whose track records go back farther than the periods for which they claim compliance with the GIPS Standards must show these additional periods. For example, if the firm claims compliance with GIPS for the most recent 5 years, but the firm and strategy have existed for 10 years, the 10-year annualized performance must be shown. Since the GIPS standards do not allow firms to link compliant and non-compliant performance periods, if this is presented on the GIPS Report to satisfy this SEC requirement, a disclosure of this conflict must be included. The following is an example of how this disclosure could be written:
   • “The inception of the firm’s GIPS compliance is 1/1/2016. Performance is presented with an inception date of 1/1/2011. Although the GIPS standards prohibit linking compliant and non-compliant performance periods, the 10-year annualized return is presented to meet local regulatory requirements set forth by the SEC Marketing Rule.”

Hypothetical Performance – Firms must make a clear differentiation (and have documented Policies & Procedures) on who may receive hypothetical performance in marketing. To receive this type of information, the recipient must be a sophisticated investor, as defined by the firm in their policies and procedures. The presented hypothetical performance must also be deemed relevant to the given recipient’s financial situation. If using hypothetical performance, firms are required to maintain a record of who it was shared with and how they met the qualifications to receive such performance.

Carve-Outs – What the GIPS standards refers to as a “carve-out,” the SEC Marketing Rule refers to as “extracted performance.” The SEC Marketing Rule also considers a composite of extracted performance to be hypothetical. Therefore, the recipients of carve-out composite performance, such as in a carve-out composite’s GIPS Report, must be qualified to receive hypothetical performance as described in the Hypothetical Performance section above.

Non-Fee-Paying Accounts – Firms must apply a model fee to any non-fee-paying accounts within composites if net-of-fee returns are presented using actual fees. Firms that apply model fees (instead of actual) to determine composite-level net-of-fee returns will not need to make any changes. The fee applied to the non-fee-paying accounts should be the highest fee that was charged historically or the highest possible fee the advisor would charge today.

Frequency/Timeliness of Updates – Marketing must be updated as of the latest calendar year-end at a minimum. However, more recent periods (such as YTD) may be required if, for example, a material shift in the performance occurred since the latest calendar year-end. It is generally expected that most firms should be able to update performance through the end of the calendar year within one month after the year ends.

• Not showing more recent, YTD performance could be considered misleading if more timely quarter-end performance is available and/or events have occurred that would have a significant negative effect on the advisor’s performance (think of updating performance to show 1Q20 to show the impact of COVID). It is important to keep in mind that the general focus of the SEC Marketing Rule is to ensure the presentation is “fair and balanced.” Part of ensuring the presentation is fair and balanced would be showing the most recent performance available regardless of whether it is favorable or unfavorable for your firm.
• Future guidance is expected to be issued, as firms have expressed concerns around the difficulty of implementing this.

Portability – Requirements for presenting portable track records are materially the same between the SEC Marketing Rule and the GIPS Standards. However, the Marketing Rule indicates that if the main individual or team responsible for managing the strategy at the prior firm leaves the current firm, then the portable period can no longer be shown.

• During the conference, there was discussion around possibly being able to continue presenting the portable track record of terminated decision-makers if knowledge of implementing the strategy has been sufficiently transferred to an individual or team at the current firm. A reasonable time-period for this transfer of knowledge could not be specified, as it would depend on the complexity of the strategy. For example, a quantitative strategy primarily managed with an algorithm would likely require less time than a more qualitative investment strategy.
• The key point highlighted was that if firms are electing to present portable track records after key individual(s) are no longer with the current firm, it is important to clearly document this knowledge transfer in case presenting the portable track record is questioned by a regulator.

Conclusion

This year’s speakers did a great job of hitting on the most relevant industry topics and providing resources to add clarification regarding the 2020 GIPS standards.

While the past two virtual conferences have each been a success, we are excited about the possibility of the next conference being in person.

If you have any questions about the 2021 GIPS Virtual Conference topics or GIPS and performance in general, please contact us.

In baseball, Batting Average is one of the oldest and most universal tools to measure a player’s success at the plate. Similarly, Batting Average is used in investment performance analysis to measure a manager’s success “at bat,” but there is significantly less cheering involved by spectators!

What is Financial Batting Average?

When used for investment performance analysis, Batting Average is a statistic that measures how often a manager or strategy outperforms its benchmark. It is calculated by taking the number of times the strategy beats the benchmark divided by the total number of instances in the period (whether daily, monthly, quarterly, etc.).

Financial Batting Average Formula

How to interpret Batting Average

Batting Average allows managers to demonstrate how consistently they outperform. The closer this number is to 1.000 (or 100%) the better. A strategy with a batting average of 0.500, has outperformed its benchmark only half the time, whereas a strategy with a batting average of 1.000 has consistently outperformed the benchmark for every period under review. For example, a strategy that beat the index 18 out of 36 months would have a statistical batting average of 0.500 or 50%.

Luckily, we hold our investment managers to a higher standard than players in the MLB. While a baseball batting average of 0.300 (or 30%) may be considered outstanding, 0.500 (or 50%) is often considered a minimum threshold to be considered successful in investment management.

Why is Batting Average Important?

Like many statistical tools, Batting Average is used to assess whether a strategy is performing according to its investment objective. If the goal of the strategy is to consistently outperform its benchmark, Batting Average is an easy calculation to assess whether this is true.

Batting Average is particularly useful in demonstrating consistency. For example, in baseball, a player with 4 RBIs (runs batted in) in a game may have had a grand slam in one at-bat and struck out every other time at the plate. Another player with 4 RBIs may have hit a solo homerun every time he batted that game. While their RBIs are the same, the second player has a much higher Batting Average for the game because he was more consistent. Similarly, when assessing an investment manager’s performance, investors are often looking for consistency – to determine if the manager had one period with significant outperformance but underperforms most periods, or if the manager consistently outperforms. Batting Average can help explain this.

One drawback to using Batting Average is that it focuses only on returns and does not consider the risk taken by a strategy to achieve those returns. It is therefore a good idea to use Batting Average in addition to other statistical measures to demonstrate skill when considering risk. The Information Ratio is a common measure used in conjunction with Batting Average. It is similar in that it evaluates a strategy’s success beyond the benchmark, but it takes into account the volatility (or risk) of achieving those returns.

Contact Us

If you have any questions about investment performance or GIPS compliance Contact Us or email Sean Gilligan, CFA, CPA, CIPM at sean@longspeakadvisory.com.

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.