Around the Peak.

TSG hosted the 21^st annual Performance Measurement, Attribution & Risk (PMAR) North America Conference on May 24^th - 25^th 2023 in New Brunswick, New Jersey. Longs Peak had the pleasure of sponsoring the event and being represented on the Performance Reporting: Beyond the GIPS standards panel on day 2 of the conference by our very own Matt Deatherage, CFA, CIPM.

With many unanswered questions still circulating on the implementation of the SEC Marketing Rule that took effect last November, there were multiple sessions that touched on this topic. Other topics included ESG and its impact on performance, maximizing the potential of AI, performance evaluation and risk when returns aren’t normally distributed, evaluating benchmark misfit risk, and other hot topics such as talent retention and outsourcing.

With many women in the industry already attending PMAR, the conference also facilitated the first in-person Women in Performance Measurement (WiPM) meeting May 23^rd. Longs Peak co-sponsored this event with TSG and sent four members of our team to the event. Interacting with so many brilliant women in different stages of their careers was a great experience, and the women of Longs Peak are looking forward to being part of the continued growth and development of the group.

ESG

ESG reporting requirements are ramping up, coming from pressure from shareholders and employees as well as in response to looming federal climate-disclosure regulations. The trend is no different for prospective investors as interest in ESG information is increasingly being requested by prospects. According to this WSJ article, “Nearly 80% of roughly 400 global institutional investors surveyed last year said companies should make investments that address ESG issues, even if doing so reduces profits in the short term.” The speaker reiterated this sentiment and said although the regulations in the US are behind Europe and Australia, he said that the SEC is getting there.

AI and Machine Learning in Investment Management

It is no secret that large language models (LLMs) like ChatGPT or BloombergGPT are increasingly being incorporated in investment management. LLMs offer powerful technologies that can be utilized for a variety of advancements from data analysis and research to providing valuable insights from financial reports and supporting decision-making. In addition, they can contribute to risk assessment, compliance, and portfolio management by analyzing data and optimizing strategies. It is our opinion that this technology will revolutionize the financial services industry and will do so rapidly.

Of course, the integration of AI and Machine Learning technology comes with advantages and disadvantages. While the technologies offer improved efficiency and accuracy, relying too heavily on this technology can introduce algorithmic biases that can impact investment decisions. As performance experts, we wonder if it will create an overreliance on historical data and as we know, past performance may not always be indicative of future results. Key takeaways from this session were to consider how your firm might utilize LLMs and Machine Learning in your own processes and that while this technology is still somewhat new, it is increasingly accessible to anyone at reasonable cost.

Performance Reporting: Beyond the GIPS Standards

The panel discussed the types and frequency of performance they’re seeing internally and externally. Depending on the asset class, monthly or quarterly external reporting is most common, while some portfolio managers have found value in utilizing daily reporting internally to see how their strategies are performing in real-time. Firms seem to be steering away from manual updates and relying more heavily on automation and external resources for reporting. Beyond the statistics required by the SEC, including visuals in their reports was touched on by the panel as well as focusing on the story the firm is looking to tell based on the goals of the specific strategy.

Firms distributing performance also need to consider the internal controls needed to ensure that they are presenting accurate performance relevant to the specific audience. The importance of audit logs and extensive internal review was stressed, and firms are constantly looking for ways to improve these processes and save time. These challenges extend to updating databases in a timely and efficient manner, with some firms opting to upload preliminary performance to meet database deadlines and then making retrospective changes as needed.

While Excel is still king in the performance world, utilizing performance systems for calculation and reporting can create efficiencies and reduce opportunity for manual error. Flexibility is key, as end users want to be able to customize reporting for their specific needs. The ultimate reporting goal for many firms seems to be aggregating performance and risk statistics from different sources, and firms have found success using dashboards and other technology to simplify these processes.

SEC Insights

With many of our clients being SEC-registered investment firms, we’ve been just as eager as the rest of the industry for additional guidance on the SEC Marketing Rule. Unfortunately, it sounds like it may be a while until additional FAQs are released. One requirement that has raised many questions is the requirement to present performance net-of-fees. “Performance” isn’t defined by the SEC, so the PMAR panel, focused on extracted performance and attribution, attempted to shed some light on what could be considered performance under the new SEC guidelines.

It's been made clear that the net performance requirement applies not only to performance of an entire composite or portfolio, but also to that of a subset of investments or a single investment. If the gross performance of a single investment is shown, net performance also needs to be presented. When presenting extracted performance, firms should apply a model fee to calculate the net return, include appropriate disclosures, and be able to support why they’re presenting this information.

This gets a little trickier when considering attribution, and many firms are still figuring out how to navigate this grey area. The SEC will likely want to see attribution net-of-fees in some cases but not others. For now, it seems providing clear documentation for what’s shown and why is key. According to the panel, things like average weight and Sharpe ratio seem less likely to be considered performance, while contribution to return seems more likely to be considered performance. Yield in particular was discussed in detail, with the takeaway being that if yield is presented in a way that it is synonymous with a return and what investors can expect to take home, this may be subject to the net performance requirement.

Some other takeaways from this panel discussion on attribution are that metrics derived from performance and those that are relative to a benchmark are less likely to be considered performance in the eyes of the SEC. Firms should be able to support their decision of what they consider performance and be aware of the context in which attribution is being presented.

This panel also touched on key deficiencies from recent SEC exams, as well as what to expect for the next round of exams. While Phase I focused on more evaluating whether firms were addressing the new rule, Phase II is expected to include a deep dive across 175-200 firms. This will also include 20-25 exams involving recalculation of performance, as well as a focus on predecessor performance and testimonials/endorsements.

Some of the deficiencies the panel touched on from Phase I were material misstatements in advertisements, manipulation of performance, omitting poor performance, and failure to present net-of-fee performance. Another deficiency noted was the lack of policies and procedures around presenting hypothetical performance. The key to presenting hypothetical performance is that recipients must be able to fully understand what is being shown, and that this performance is not being distributed to a retail audience. You also need to have the ability to recreate any hypothetical performance presented, as this has the potential to be tested by the SEC.

To get ready for the next phase of SEC exams, firms should make sure their policies and procedures are designed to prevent violations of the marketing rule and that their marketing materials comply. We recommend extending this review to your website to ensure historical information published prior to adoption of the new rule is also in compliance. One suggestion from the panel was to leverage other firms in the industry to see what types of disclosures are being used. Many large firms are putting a lot of time and resources into navigating the marketing rule, so leveraging these firms as best practice is encouraged.

WiPM Group

Officially launched in late 2022, the Women in Performance Measurement (WiPM) Group was developed as a resource for women in the investment performance industry to connect with, learn from, and uplift one another. With initial members of the group spread across multiple regions and countries, the first in-person meeting had an impressive turnout of over 50 attendees.

The meeting featured Lisa Kaplowitz as its keynote speaker. Kaplowitz is a professor at Rutgers Business School and is the Executive Director at Rutgers Center for Women in Business. Her background includes everything from taking part in the landmark Title IX case to multiple CFO positions. Throughout her career, Kaplowitz has remained a champion of women and challenging the status quo.

Kaplowitz shared statistics supporting that the majority of women in C-suite positions competed in athletics, with nearly half of those executives being previous college-level athletes. This connection may not be all that surprising when you consider the life lessons around discipline, resiliency, and teamwork that are taught through athletics and the valuable leadership skills that are developed through those experiences. She also offered some insightful information on maladaptations women have to endure to survive in the workforce today and offered suggestions for addressing them. This topic really seemed to resonate with the group.

Another topic discussed was how to make the workplace “work” for women, which led to some insightful conversations during the WiPM panel discussion that touched on work life balance and the unique challenges women face in the workforce, particularly the performance measurement industry.

The group is working out details of a mentorship program that will help facilitate relationships between women across the industry and allow them to share the knowledge and experience gained throughout their careers. This program is expected to launch in the fall of 2023 and is open to all women within the WiPM group.

Anyone interested in the WiPM Group is encouraged to contact us to get connected.

Conclusion

This year’s PMAR speakers offered a lot of great insights on topics related to investment performance measurement and challenges facing the industry.

We enjoyed connecting with other performance measurement professionals in-person and are looking forward to attending future PMAR and WiPM events.

If you have any questions about the 2023 PMAR Conference topics or GIPS compliance and performance measurement in general, please contact us.

What is Max Drawdown?

Max drawdown is a metric used to measure the largest peak-to-trough decline in the value of an investment over a specific period. Stated differently, it is the greatest cumulative percentage decline in net asset value due to losses sustained by the strategy. It is expressed as a percentage of the peak value and represents the maximum loss an investor would experience if they invested at the peak and sold at the trough. This ratio is commonly used by investment firms that say their strategy protects on the downside. Max drawdown helps demonstrate how effectively a manager performed when evaluating downside risk.

Max Drawdown Calculation

Example Max Drawdown Calculation

Max drawdown is calculated as a percentage. For example, if you want to know the max drawdown for a strategy since inception, and during that time it reaches a peak of $120, and then declined to a minimum of $90, the max drawdown would be -25.0% = (($90-$120)/$120).

How to Interpret Max Drawdown

Max drawdown is an important metric to consider when evaluating the risk of a strategy, as it provides a clear measure of the potential loss that may occur. It is one of the primary ways investors measure the risk of a strategy, especially when considering risk tolerance.

Max drawdown can be used as a tool for comparing similar strategies. Consider the following hypothetical scenario where the returns are the same, but reviewing max drawdown helps illuminate the risk taken to achieve that return:

Risk-averse investors would prefer Strategy B over Strategy A because it provides the same level of return with lower risk (as measured by max drawdown). Strategy B also performed better than the benchmark in this scenario, indicating that the strategy has performed better at managing downside risk.

Without considering the risk of the strategy, the investor would not have a sense of which investment best suits their risk profile as their decision would be based on returns alone. Considering max drawdown allows the investor to make a more informed decision while considering downside risk. Going one step further and using the max drawdown to calculate the Calmar ratio can be even more helpful as this ratio combines both return and risk into one metric.

What is the Calmar Ratio?

The Calmar ratio utilizes max drawdown to create a ratio of return to risk that helps investors compare strategies based on the level of return achieved after adjusting for the risk taken. This ratio adjusts the annualized strategy return by the maximum drawdown of the strategy. A higher Calmar ratio is preferred as that would represent better strategy-level performance on a risk-adjusted basis. Calmar is also used by firms interested in demonstrating how they performed in managing downside risk.

Calmar Ratio Calculation

Notice that a negative sign is placed in front of the maximum drawdown in the denominator. The negative sign will allow for the Calmar ratio to be calculated as a positive number since max drawdown statistics are negative by nature. The positive statistics make for an easier interpretation and comparison when reviewing different strategies side by side.

Example Calmar Ratio Calculation

Unlike max drawdown, the Calmar ratio is calculated as a decimal. While some may believe a Calmar ratio above a specific threshold is “good,” the ratio is best interpreted when comparing multiple strategies, or a strategy against a benchmark. For example, a strategy with an annualized return of 9.0% and a -25.0% max drawdown, results in a Calmar ratio of 0.36 = (9.0%/25.0%). Without another strategy or benchmark to compare, it’s hard to know if this result is good or bad. Thus, it’s best to use it as a comparison tool.

How to Interpret the Calmar Ratio

The Calmar ratio can be helpful when comparing strategies by creating statistics that are easily comparable across investment options. This statistic can also be used for various performance periods, which allows investors to make a fair comparison across investment strategies with different inception dates. Using the Calmar ratio helps investors compare results between strategies that may have different annualized returns and different max drawdowns. Let’s build off the prior example with some slight changes to show how the Calmar ratio can help in a less straight forward example where both the returns and max drawdown are different between the options:

If the above scenario was presented to an investor, it may be difficult to pick between Strategy A and Strategy B. Strategy A has the higher return but is riskier based on the max drawdown. Strategy B has the lower return but is less risky based on the max drawdown. For a risk-averse investor, this could be a difficult choice to make without any other information available.

Once the Calmar ratio is introduced, it provides a clearer picture of which option has the best risk-adjusted performance. Although an investor may be tempted with the higher returns of Strategy A, a risk-averse investor would still select strategy B due to the higher risk-adjusted performance demonstrated with the Calmar ratio. And although the strategy return did not beat the benchmark, on a risk-adjusted basis (as represented by Calmar) Strategy B is preferred.

Conclusion

Like many risk-adjusted statistics, the max drawdown and Calmar ratio are very helpful in reviewing strategy performance. These statistics can be helpful in isolation but are most useful in comparing strategies or comparing against a benchmark. Each statistic tells a different piece of the story and can be very powerful when combined with other risk statistics to provide investors with a better understanding of the return vs risk profile of the strategy or investment.

Longs Peak is pleased to announce that Partner and Co-Founder, Jocelyn Gilligan has been named a GenXYZ Top Young Professional by ColoradoBiz Magazine.

As ColoradoBiz states, “They’re uncommon achievers, whether as entrepreneurs, CEOs, nonprofit leaders, visionaries critical to their companies’ success or, in some cases, all of those roles. This year’s Top 25 Young Professionals figure to continue making a difference professionally and in their communities for years to come.”

Jocelyn grew up in Boulder, CO and graduated from the University of Colorado. She started her career at Ernst & Young in New York City where she worked on their Financial Services Transfer Pricing Team. She transferred with EY to their office in Shanghai and then eventually to Hong Kong. Jocelyn left EY as a Manager and relocated back to Colorado where she and her husband started a family. Soon thereafter, Jocelyn and Sean founded Longs Peak out of a small one-car garage in their home in Longmont, CO. Now running a thriving team of 14, Jocelyn has weathered the ups and downs of entrepreneurship. She credits a lot of their success to their amazing team and the community of entrepreneurs they live near and network with (Longs Peak is an active member of EO (Entrepreneurs Organization)).

Jocelyn is a voting member of the PTO at her children’s school and a member of Women in Investment Performance Measurement, a group recently founded to support women in the investment performance industry.

About ColoradoBiz’s Top 25 Young Professionals

The 13th annual Gen XYZ awards is open to those under 40 who live and work in Colorado — numbered in the hundreds, making for difficult decisions and conversations among judges, as always. Applications were judged by our editorial board based on career achievement, community engagement and their stories of how they got to where they are now.

About Longs Peak

Longs Peak is a purpose and values-driven company. It is our mission to make investment performance information more transparent and reliable—empowering investors to make better, more informed investment decisions.

At the onset, we were looking to help smaller investment managers by giving them access to professional performance experts and tools typically only available to very large firms. We know that our work enables emerging managers to compete with the big guys and helps facilitate their growth. We strive to be our clients’ most valued outsource partner and to be known for our exceptional client service. We know that providing exceptional client service means that we must first create a culture that lives by the ideals we are trying to create for our clients. A place where incredibly talented individuals are empowered to put their best work into the hands of clients that truly value what we do. As a firm, we recognize that our greatest asset is people – both those we work with and those we work for. We continue to evolve into something that represents the needs of both of these groups and hope someday a GIPS Report is provided to every prospective investor in the world.

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As in years past, we are reposting this article. While your GIPS standards policies and procedures rarely need to materially change, as the standards, regulations and your firm evolves, performing a review of your GIPS compliance each year is beneficial to ensure your documented policies continue to align with your firm’s actual practices.

This year, conducting a review of your firm’s GIPS compliance is especially important because of the SEC’s New Marketing Rule that came into effect in November 2022. For information specific to the SEC Marketing Rule, please check out our Marketing Rule Checklist or the CFA Institute’s whitepaper on Reconciling the GIPS Standards with the SEC Marketing Rule.

The Right Team & Involvement

Even without the release of the New Marketing Rule, 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 standards 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 standards expert internally, or need independent advice about your policies and procedures, a GIPS standards consultant can be hired to help.

High-Level GIPS Standards 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?
• Did the New SEC Marketing Rule cause you to make changes to how you manage your composites or present the composite’s performance results?
• 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 presenting any new statistics in your GIPS Reports that now should have error correction thresholds in your error correction policy? For example, if you added 1-, 5-, and 10-year annualized returns to your GIPS Reports as part of complying with the SEC’s Marketing Rule, is your error correction policy clear on how errors to these numbers will be handled?
• Are you satisfied with the service received from your GIPS standards verifier for the fee that is paid?
• Is there any due diligence you need to conduct on your verification firm to ensure data security standards are being met or to confirm there is no breach of independence if the same firm is providing additional services to your firm beyond GIPS standards verification?

Changes to Regulations/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. It is important to keep in mind that it is not only when updated standards are released that guidance is issued that could impact the way you implement the standards for your firm. Guidance may also be issued in the form of guidance statements or Q&A’s, which also must be followed by all GIPS compliant firms.

If your firm is verified or works with a GIPS standards consultant, these GIPS standards experts are likely keeping you informed of any changes to the standards. The best way to check for changes yourself is to visit https://www.gipsstandards.org/. Specifically, you should check the “GIPS Standards 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.

As a result of the SEC Marketing Rule, there were several changes that may affect your GIPS Reports. If you are not aware of these changes, there are a number of resources available to help you better understand what is required (see the links listed in the second paragraph of this post).

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 SEC commonly review firms’ policies and procedures to ensure that 1) the document includes actual procedures and is not simply a list of policies and 2) the stated procedures truly represent the procedures followed by the firm. We expect the SEC to be particularly vigilant in their reviews following the release of the New Marketing Rule.

Meaningful Composite Structure

The section of your GIPS standards 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 standards 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 Standards 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 standards committee rather than your GIPS standards department or manager. The reason for this is that opinions of what constitutes a material error may 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 Standards 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 ensuring the firm conducting your verification is still considered independent from your firm. This is especially important if your firm receives multiple services from your verifier that could overlap.

With several mergers, acquisitions, and start-ups in the verification community over the last few years, you may want 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 the composite construction requirements of the GIPS standards and 2) whether your firm’s GIPS standards policies and procedures are designed to calculate and present performance in compliance with the GIPS standards. Where they differ is in the fees charged and process followed to complete the verification.

Regarding fees, much of the difference between verifiers is based on their level of brand recognition rather than differences in the quality of their service. In our experience, 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, each verifier has its own method for how it arrives at an opinion on the points listed above. If you found last year’s process frustrating, there’s no harm in seeing what else is available. Our team has worked with most, if not all the verifiers out there and is happy to share our experience on how each verifier works. In addition, some verifiers offer access to a team and other ancillary services while others are a one-person shop. Here, you’ll want to consider 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. Prior to the Covid-19 era, some verifiers conducted the verification on-site while others worked remotely. While remote work is now the norm, on-site work, in general, is making a comeback. You’ll want to consider which approach 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.

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 at risk.

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 us or email Sean Gilligan at sean@longspeakadvisory.com.

CFA Institute hosted the 26th annual GIPS Standards Conference on October 25^th - 26^th 2022 in Boston, Massachusetts. This was the first time the GIPS Standards Conference was hosted in-person since the 2019 conference in Scottsdale, Arizona. It was great to be back together with so many familiar faces.

With the SEC Marketing Rule taking effect shortly after the conference, the hottest topic of this year’s conference was the two-hour session on this topic. Other topics included best practices for the implementation of the GIPS standards, information on ESG attribution, data visualization, practical advice for IRR calculations, OCIO performance issues, model portfolio programs and general updates on the GIPS standards.

SEC Marketing Rule

Michael McGrath, CFA, Partner with K&L Gates and Christine Schleppegrell, Acting Branch Chief with the Securities and Exchange Commission (“SEC”) did an excellent job addressing some of the grey areas relating to the presentation of performance in advertising.

Schleppegrell emphasized that the guidance is intended to be principles-based so there are not always back and white answers to these grey areas. Most important is that firms always consider if their advertisement is “fair and balanced” and appropriate/meaningful for the intended audience.

McGrath was able to share some more opinions on how firms can address some of the grey areas. Below are some key items worth highlighting:

Gross vs. Net for “Performance-Related” Statistics

The rule is clear that gross performance cannot be shown unless net performance is also shown. But for many trying to interpret this guidance it begs the question, what is “performance”? Is performance limited to only the actual returns of the strategy or are other risk measures and attribution considered “performance” as well?

A key distinction that was made is that performance demonstrates what the investors “actually took home.” So, charts that show the growth of a dollar would likely be considered “performance” and need to show net returns. On the other hand, a risk measure like standard deviation that indicates volatility, but does not actually tell us what the investor took home would likely not be considered “performance” and, therefore, can be shown based on gross returns without also showing net.

Performance appraisal measures like Sharpe ratio are a little closer to showing what an investor took home but are still just “performance-related” rather than “performance.” Attribution also likely fits into this “performance-related” category where it is likely okay to show based on gross data; however, for any of these performance-related measures, if choosing to show based on gross data rather than net you should:

1. Document internally why you feel it is more appropriate/meaningful to use gross data for these measures, so you are prepared to justify its use if questioned by an examiner; and
2. Present net performance (i.e., net time-weighted returns) for the strategy in conjunction with these other “performance-related” figures that are presented using gross performance data.

Calculating Net Performance

Calculating net performance for a composite can get tricky when a composite includes non-fee-paying accounts, accounts with greatly reduced fees, accounts that pay their fee by check, or accounts that pay their fees from other accounts managed by the same manager (we've written a separate post on how to account for these fees here). Firms presenting net performance based on actual fees must ensure fees are applied to every account in the composite even if some are non-fee-paying. While the GIPS standards allow firms to exclude non-fee-paying accounts from composites, the SEC Marketing Rule does not specifically allow this. If excluding non-fee-paying accounts, you will need to ensure that excluding them does not make your composite performance materially better. While a model fee can be applied to each non-fee-paying account, the easiest, and most conservative approach is simply to apply a model fee at the composite level.

Even when all accounts in the composite are fee-paying, if using actual fees to calculate net performance you should consider if the results are meaningful for your current prospects. For example, if historically you charged 75bps, but your current fee schedule for new prospects is 1.5%, it could be considered misleading to use net performance based on actual fees. It is considered more appropriate to apply a model fee based on the highest fee a prospective client would pay.

Materiality was also discussed with regards to non-fee-paying accounts in composites. Specifically, a question was asked regarding the need to adjust for non-fee-paying accounts in composites when the amount of non-fee-paying accounts in the composite is very small. It was confirmed that materiality can be considered, and no adjustment is needed if the impact is immaterial. Of course, materiality can be difficult to define so if your firm is electing to not adjust performance for the non-fee-paying accounts in the composite, you should document your justification for this. This documented justification should make it clear why the results are meaningful and appropriate for your intended audience without any adjustment.

Using Representative Accounts for Attribution

Many firms are accustomed to using representative accounts for attribution rather than using a composite for attribution. This may continue to be okay if the firm can demonstrate that the results for the representative account are not better than the composite and also that the account has attributes that truly are representative of the strategy. Generally, this attribution would be shown in conjunction with composite performance, so the representative account is only used for “performance-related” statistics and not for the performance itself.

Customized Requests for Prospects

If a prospect requests a customized report of information that typically would not be allowed in an advertisement, it may be okay to provide this information to meet their specific customized request. However, if you have a report saved with this type of information that you provide to more than one prospect when requested, this may no longer be considered customized and may then be considered an advertisement.

For example, if you create a report of gross equity returns extracted from a balanced strategy to provide upon request, this may be deemed an advertisement if you provide the same report to multiple prospects. In other words, it needs to be custom tailored each time to meet the unique request of a prospect to fall outside of the Marketing Rule. When in doubt, it is safest to assume it will be considered an advertisement and include all required statistics and disclosures.

GIPS Standards Implementation

I had the pleasure of speaking on this panel together with two other industry experts with experience in GIPS standards verification and consulting. Together, we emphasized the importance of ensuring GIPS compliant firms take the time to customize their policies and procedures to be meaningful for their firm. Often firms create their policies and procedures using a template when first becoming GIPS compliant. It can be hard to include detailed procedures at that stage because it is all so new. A key takeaway from this session was to go back to your policies and procedures and take a fresh look to consider if they are clear and complete or if more detailed procedures should be added now. If you would like some additional guidance, we have summarized a list of the main topics to consider updating in a previous post here.

Involvement from key stakeholders in your firms GIPS compliance was also discussed. Whether it be for determining error correction materiality thresholds, defining composites, or other important decisions for your GIPS compliance, it is important to include stakeholders from around your firm. Specifically, members of your firm from performance, operations, compliance, portfolio management, sales & marketing, and executive management should be consulted to help create robust policies that consider different facets of your business. Often, firms create a GIPS Standards Oversight Committee with members from each of these areas to help facilitate effective internal communication between departments regarding the implementation of the firm’s GIPS compliance.

Detailed composite construction policies were also discussed such as minimum asset levels and significant cash flow policies. The key takeaway from this was to ensure you are not over complicating policies. Implementing composite minimums and significant cash flow policies can be beneficial in some cases, but if you do not have a system to help automate the monitoring and implementation of these policies, the risk these policies add may outweigh the benefit. Depending on the size of the composite, these policies may only have an immaterial impact on the composite results. Since implementing policies like this (especially when not automated) increases risk of errors in composite membership, it is important to consider the potential administrative burden when determining whether you want to have these optional policies for your composites.

OCIOs and GIPS Compliance

Many OCIOs (Outsourced Chief Investment Officers) are currently working toward GIPS compliance. With the way these firms operate with heavily customized portfolios, defining discretion and constructing composites can be very challenging. With this in mind, additional guidance for OCIOs claiming compliance with the GIPS standards is in the works. An initial consultation paper is expected mid-2023 that will be open for public comment. Finalized guidance for OCIOs will be available after there has been time to consider the feedback received from the public.

Conclusion

This year’s speakers did a great job providing clarification on the SEC Marketing Rule and other relevant topics that impact GIPS compliance and investment performance.

We were happy to be back in-person to attend the conference in Boston and look forward to hearing where next year’s conference will be!

If you have any questions about the 2022 GIPS Standards Conference topics or GIPS and performance in general, please contact us.

Longs Peak is specialized in helping investment firms calculate and present investment performance. As a team, we have either reviewed or created thousands of factsheets for the 200+ investment firms we’ve worked with. Over the years, we’ve come to realize that many investment managers struggle to create fund factsheets that help potential investors truly understand their firm and strategy. Many end up with generic leaflets of information that don’t actually help get interested investors in the door. Others make them because they feel like they have to and piece together an abundance of data without cohesive direction. Unless you have an in-house marketing team that’s specialized in advertising for investment managers, you might feel like you don’t know where to begin.

So how can you decide what to include when making a factsheet for your strategies? Keep reading to find out.

Where to begin

There are three things that you should consider before you make (or hire someone to make) your factsheets:

1. Who is the target audience (i.e., your core client)?
2. What is the primary objective of your strategy?
3. How do you make investment decisions?

Once you know these three things, design is really just puzzling together the critical elements and aligning it with your branding.

Understanding your Target Audience

While this may seem obvious, knowing your target audience can make a huge difference in the success of your factsheets (which can be measured by how many requests you get for additional information). We find that firms often put together a factsheet with information they most commonly see other firms including – risk-adjusted performance statistics, sector allocations, top holdings and more – without much consideration for who will be reading the document. While this is not a bad place to start, too often factsheets end up generic and are not meaningful to the reader. It is important that your factsheet helps your prospects understand your investment process and how your strategy can help them achieve their goals. Picturing who you are communicating with as you develop the factsheet will help ensure your message is clear and focused on what is most important to them.

Institutional investors, such as large pension funds you’d like to sub-advise for, will want to see performance appraisal statistics that demonstrate how your strategy performed on a risk-adjusted basis and how this aligns with your investment objective and process. We’ll discuss more about this in the following sections, but most importantly, your factsheet should tell the story of your investment process – what you set out to do and how you achieved it (or what happened if you didn’t). It’s sort of like a report on your strategy’s OKRs (Objectives and Key Results).

Retail investors are likely less prepared to interpret complicated statistics and care more about how you’re going to help them achieve their future goals (think future college tuition payments, that retirement home in the mountains, etc.). For this type of investor, it may be better to incorporate more absolute return visuals like growth-of-a-dollar line graphs and text that explains how you plan to help grow their capital while protecting it from material losses. Or how you’d make customized investment decisions with their goals in mind.

Regularly, firms have a target audience that is somewhere in between. Sophisticated enough that they understand some performance appraisal measures, but not so sophisticated that they understand what they all mean. In this case, you’ll want to consider your target audience’s goal in investing their money with you. Whether they’re saving for retirement, supporting the financial needs of a loved one, or looking to add risk to a well-diversified portfolio, knowing their objective will help you be clearer about how to communicate to this audience.

And remember, although your factsheet should be designed with your ideal client in mind, there may be situations where your target audience differs from this core customer. For example, if you normally target retail investors but get the opportunity to pitch to a large RIA, you may want to customize the factsheet to cater to this client type. In this case, just follow these same steps with this client in mind.

Need help defining your target audience? You can use this GUIDE to help you define your core customer (or client profile).

What is the Primary Objective of your Strategy?

The key message you want your factsheets to convey is how your strategy goes about identifying drivers of value/returns. You want to communicate your end-goal (your strategy objective) and then demonstrate through statistics, graphs, and charts how you achieved it (your key results).

Whether your strategy is primarily focused on beating the benchmark on the upside or protecting capital on the downside, the statistics shown should act like a scorecard that demonstrates how you performed specifically on that objective. If your strategy’s primary goal is to beat on the upside, you’ll want to show things like Upside Capture (usually shown together with Downside Capture), Batting Average, Sharpe Ratio, and Alpha. Alternatively, if your strategy aims to protect on the downside, things like Max Drawdown, Downside Capture (again usually shown with Upside Capture), or Downside Deviation will be more relevant.

If you manage a strategy that exhibits a non-normal return distribution (e.g., you manage a strategy with options that create positive spikes in performance), you’ll want to include risk measures designed to consider these asymmetrical returns. These measures could include things like Sortino Ratio and Semi-Deviation.

Regardless of the strategy type, be sure to take the time or consult with someone that can help you select statistics that support your investment objective and display how you’ve done on an absolute and risk-adjusted basis.

This information should also be used internally as a feedback loop to assess what worked and didn’t work. The findings from this reflection can also be used in market commentary – either in your factsheet or as a quarterly market newsletter – to explain performance results for the current period. Doing this creates transparency and builds trust. Furthermore, it demonstrates to prospects that you are paying attention to what is happening in the market and taking action to address these changes.

Want to learn more about different performance appraisal measures? We’ve written several posts on different measures available and when you might use them.

How do you Make Active Investment Decisions?

If you – or your sales team – don’t know the answer to this question, it’s probably time to make sure you have this message clear. Because if your team doesn’t know how to explain it, it’s going to be confusing for a prospect. Investors of all types typically want to understand the investment process – how a strategy is implemented and how you manage the trade-off between expected return and risk exposure. You can help them understand these things by clearly identifying where you are making active investment decisions and then illustrating that information in your factsheet.

Frequently, firms don’t know what to include to help explain the story of their investment process but answering a couple simple questions can help. Consider the following:

• Are you performing fundamental or quantitative (systematic) analysis?
• Do you characterize your strategy as top-down or bottom-up?
• Do you consider micro or macroeconomic factors in your analysis?
• Do you have a value- or growth-based approach?
• Do you have geographic/country-based factors in your selection process?
• For spread-based bond portfolio investments, how do you select fixed income issuer types, industries, and instruments? How do you define your universe and narrow that down by credit quality, duration and taxability?

We often see firms that want to include information in their factsheets that really has no relevance to their active decision making. For example, if your investment process involves bottom-up fundamental analysis focused on stock selection with no active decisions to over- or under-weight at the sector-level, showing sector weights in comparison to the benchmark is less relevant than it is for a manager that specifically makes active decisions on sector exposures. Does showing where you ended up this quarter provide any meaning to the reader? If not, it’s best to find something that does.

The same goes for other common factsheet components like holdings and asset allocation. If you manage a strategy that focuses on macro-level variables and invests in a handful of ETFs, swaps and futures contracts to capture macro dynamics to generate returns, showing your top holdings may provide little meaning to the reader and it could even reveal trade secrets you may not wish to divulge. Perhaps in this case, focusing on describing the macro-level environment or trends and how you added exposure to them may be more meaningful.

Having clarity about where active decisions are made will help you select the right information to show. Remember, most factsheets are 1-2 pages in length so there’s not a lot of real estate to waste, especially if your disclosures take up half a page!

The new SEC Marketing Rule

Finally, the SEC’s new Marketing Rule, which is set to take effect on November 4, 2022, has a variety of requirements for presenting investment performance in advertisements. It is crucial that your factsheets follow these requirements. If you have not taken the steps necessary to prepare for these changes, we strongly encourage you to have your factsheets and performance information reviewed to make sure that any advertisement you make has been prepared with the new requirements in mind. Here’s a checklist of key performance-related considerations to help get you started.

Conclusion

The main objective of publishing and distributing fund factsheets is to get you meetings with more prospective investors. If you’re not getting the interest you think you deserve, perhaps it’s time to consider how effective your fund factsheets are at communicating your performance to your core customers.

From our small business to yours, there are many books written about goal setting. As a firm, we subscribe to the OKR method and recommend reading Measure What Matters by John Doerr. While it’s not specifically intended for investment advisors or analyzing investment returns, the concepts can be helpful in outlining how to set objectives for your investment strategies and then use performance statistics to measure the key results.

If you are interested in learning more about how Longs Peak can help you create better prospect engagement through factsheets and pitchbooks, contact jocelyn@longspeakadvisory.com.

Cash flows are frequently mentioned throughout the GIPS standards, and there can understandably be confusion around the terms “large cash flow” versus “significant cash flow.” While these terms sound very similar, they refer to different concepts and each play an important role in performance calculations and composite construction for firms that comply with the GIPS standards. It is also important to note that although they are called “cash” flows, this term refers to any type of external capital flow (cash or investments) entering or exiting the portfolio.

The key difference to remember is that the “large” cash flow requirements are focused on ensuring that the methodology used to calculate time-weighted returns (TWRs) is as accurate as possible. Conversely, the guidance relating to “significant” cash flows is concerned with a portfolio manager’s ability to fully implement the intended strategy. We discuss these differences in more detail below.

What are Large Cash Flows?

A main consideration for portfolio-level calculations is the treatment of external cash flows. As of the start of 2010, the GIPS standards require firms to value non-private market investment portfolios at the time of each large cash flow, in addition to the last business day of the month. The purpose of this requirement is focused on the accuracy of the performance calculations. Methodologies that daily-weight external cash flows based on the amount of time they were in the portfolio, such as Modified Dietz, begin to lose their accuracy as the size of the cash flow increases, especially during volatile market periods.

What is considered “large” is up to each firm to define for themselves. Historically, the default setting for many portfolio accounting systems was set to revalue for cash flows that are 10% of the portfolio’s value or larger. Many systems now revalue portfolios daily, which means they essentially have a threshold of 0%. What is most important is to choose a threshold that provides accurate results, even if you're not revaluing every day or for each cash flow. While 10% is still the most common threshold for firms that do not revalue for all cash flows, some firms set thresholds as high as 20%; however, anything higher than 20% is uncommon.

Firms must define the appropriate large cash flow threshold at the composite-level with consideration for factors such as the nature of the strategy, its volatility, and its targeted cash level. Some portfolio accounting systems have the option of implementing a large cash flow policy at the asset-class-level, although it’s most common to see large cash flows defined in terms of a percentage of overall portfolio assets.

While the GIPS standards allow some flexibility in how TWRs are calculated, the methodology used must meet certain criteria. When calculating TWRs monthly, firms must calculate sub-period returns at the time of all large cash flows and geometrically link the sub-period returns. The Modified Dietz method, which weights each external cash flow by the amount of time it is held in the portfolio, is a common methodology used in calculating a TWR when cash flows do not exceed the threshold set to define “large” cash flows. Details of the calculation methodology used for portfolio-level calculations must be documented in a firm’s GIPS policies and procedures (GIPS P&P).

Significant Cash Flows

While the requirements relating to “large” cash flows are focused on the accuracy of performance calculations, the purpose of establishing policies relating to “significant” cash flows are designed to help identify when portfolios should be temporarily removed from composites. The GIPS standards recognize that very large external flows of cash or investments can significantly impair a firm’s ability to implement a portfolio’s intended strategy, causing the portfolio’s performance to deviate from that of the composite. Firms have the option to establish a significant cash flow policy that temporarily removes a portfolio from the composite to avoid the disruptive effects of significant cash flows.

Firms adopting a significant cash flow policy must define “significant” at the composite-level, and the policy may differ between composites. Firms should determine the threshold by considering factors such as the liquidity of the strategy’s investments and the time it takes the firm to invest new money or raise funds for a client-requested distribution. The significant cash flow threshold may be based on a specific dollar amount, but it is more commonly based on a percentage of the portfolio’s market value. Firms may define a significant cash flow as a single flow or as an aggregation of flows within a stated period.

The policy may only be applied prospectively. Firms should consider whether a significant cash flow policy is needed during the initial construction of a composite, although the policy can be changed going forward with proper documentation. The concept of a significant cash flow applies only to composites presenting TWRs and does not apply to pooled funds presented in GIPS Pooled Fund Reports. Details on a composite’s significant cash flow policy must be documented in the firm’s GIPS P&P, as well as disclosed in the composite’s GIPS Report.

Summary of Key Differences

Large Cash Flow Policy

• Requirement for firms calculating returns monthly
• Portfolios experiencing a large cash flow remain in the composite
• Purpose is to improve the mathematical accuracy of portfolio-level calculations

Significant Cash Flow Policy

• Optional policy
• Portfolios experiencing a significant cash flow are removed from the composite for a specified period
• Purpose is to ensure composite-level performance results are not distorted by very large cash flows that were not controlled by the portfolio manager

A firm can establish both a large cash flow policy and a significant cash flow policy. While these two thresholds are determined independently from one another, it is generally expected that the significant cash flow threshold is higher than the large cash flow threshold. Firms are not allowed to set a significant cash flow threshold equal to or lower than the large cash flow threshold for the purpose of avoiding revaluing portfolios.

If you need assistance calculating performance or deciding which GIPS policies make the most sense for your unique strategies, please contact us to find out how we can help.

The Treynor Ratio measures the excess strategy return per unit of systematic risk. The Treynor ratio is one of many performance metrics that illustrates how much excess return was achieved for each unit of risk taken. While the numerator is the same as the numerator used for the Sharpe ratio, the denominator, which is how we adjust for risk, is different. The Sharpe Ratio adjusts for risk using standard deviation, which represents total risk, while the Treynor Ratio uses beta, which represents systematic or market risk. For more information on the Sharpe Ratio, please check out What is the Sharpe Ratio?

Treynor Ratio Formula

Annualized Treynor Ratio

When calculating this ratio using monthly data, the Treynor Ratio is annualized by multiplying the entire result by the square root of 12.

What is a Good Treynor Ratio?

The Treynor Ratio is a ranking device so a portfolio’s Treynor Ratio should be compared to the Treynor Ratio of other portfolios rather than evaluated independently.

Since the Treynor Ratio measures excess return per unit of risk, investors prefer a higher Treynor Ratio when comparing similarly managed portfolios.

Example Treynor Ratio Calculation

Suppose two similar strategies, Strategy A and Strategy B, had the following characteristics over one year. For this period, the average monthly risk-free rate is 0.10%.

Please note that the Treynor Ratio calculated in this example is based on monthly data and, therefore, needs to be annualized to get the result. The full calculation is completed as follows:

Although the strategies have the same average monthly return over the one-year period, the Treynor Ratios differ due to their differences in systematic risk (i.e., beta). That is, Strategy B is less sensitive to market movements, while Strategy A is more sensitive to market movements, indicating that Strategy A took on more systematic risk than Strategy B. Despite the additional systematic risk taken by Strategy A, the average monthly return achieved was the same between the two strategies. Therefore, Strategy B has a higher Treynor Ratio because it achieved a greater return per unit of systematic risk. Because Strategy B has a higher Treynor Ratio, it would be preferred over Strategy A for an investor deciding between the two.

How to Interpret Treynor Ratio

As mentioned, a higher Treynor Ratio is preferred. However, when comparing similar investments, a higher Treynor Ratio simply means it’s better. Holding everything else equal, there’s no way to interpret how much better. In other words, a Treynor Ratio of 0.50 is not necessarily twice as good as one that’s 0.25.

A key component to ensuring the Treynor Ratio is meaningful for the portfolio is to verify that the benchmark being used to measure beta is appropriate for the given strategy. In addition, the Treynor Ratio is difficult to interpret when it is negative (this can happen if there is a negative return or negative beta). Thus, the inputs must be positive to provide a meaningful result.

Why is Treynor Ratio Important?

The Treynor Ratio is important when assessing portfolio performance because it adjusts for risk. Comparing returns without accounting for risk does not provide a complete picture of the strategy.

The Treynor Ratio is widely used for strategies that will be added to a broadly diversified portfolio. When part of a broadly diversified portfolio, it is assumed that any unsystematic risk in the strategy will be diversified away, making it appropriate to focus only on systematic risk rather than total risk when “risk-adjusting” the returns.

Treynor Ratio Calculation: Using Arithmetic Mean or Geometric Mean

Because the Treynor Ratio compares return to risk (through Beta), Arithmetic Mean should be used to calculate the strategy return and risk-free rate's average values. Geometric Mean penalizes the return stream for taking on more risk. However, since the Treynor Ratio already accounts for risk in the denominator, using Geometric Mean in the numerator would account for risk twice.

This article is part three of a three-part series on how to survive a GIPS verification. If you haven’t had a chance to read parts one and two, we recommend reading those first. The first part covers tips and tricks for setting up your verification for success. The second part covers recommendations for kicking off the verification and provides context about the initial data requests made by the verifier.

In this article, we describe how to get through the actual verification testing, which tends to be the most time-consuming aspect of a GIPS verification. Specifically, we discuss how the testing sample is determined and then dive into the details of each major testing area. Plus, we include advice to help you determine what to provide to satisfy the verifier’s requests.

How the Testing Sample is Determined

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.”

At this stage, the verifier has already reviewed your firm’s GIPS policies and procedures and likely confirmed that they have been adequately designed. The focus now is on whether these policies have “been implemented on a firm-wide basis.”

To test this, a sample must be selected. The size of the sample depends primarily on three things:

1. The number of portfolios managed
2. The number of composites maintained  
3. The verifier’s risk assessment of your firm

If you have had many errors in prior verifications or if your initial data provided to kick-off the verification had errors, the risk assessment will be high and the sample selection will likely be larger than average.

With that in mind, it is always a good idea to do your own review of your firm’s policies and procedures and data prior to providing anything to the verification firm. Even if issues were identified in the past, starting this pre-review now can help the current verification go faster and with less errors, potentially lowering the risk assessment and sample size for future verification periods.

What to expect with the Verification Testing Request

All verification firms are different in how they structure their testing process. They may have different names for the types of testing they do, but the main purpose is the same. The most typical types of testing include:

• Membership Testing
  • Entry Testing
  • Exit Testing
  • Outlier Testing
• Non-Discretionary Testing
• Return and Market Value Testing

Before diving into pulling and providing the requested documents, it is important to review the full request to ensure you are clear on what the verifier is trying to confirm. When not sure what to provide, it may be helpful to have a call with the verifier to discuss what is available. Knowing exactly what the verifier is trying to prove out makes it much easier to provide meaningful support. Blindly providing documents that may not tell the full story of what’s happening with the selected portfolio may lead to more questions/follow up.

Keep in mind that, the verifier prefers reviewing the most independent information available. For example, a contract signed by the client is typically preferred over an internal memo, but signed documentation from the client is not always available. To give you an idea of how to determine what to provide, below is a hierarchy of the preferred support:

1. Dated Correspondence Written or Signed by Client that Supports the Selected Testing Item
   • Contract and/or investment guidelines
   • Signed Investment Policy Statement
   • Termination letter
   • Email written by the client
2. Dated Notes Written by your Firm at the Time the Selected Testing Item Occurred
   • Email from your firm to the client
   • Email sent internally documenting the issue selected for testing
   • CRM notes written by your firm
   • Memo written by your firm saved to the client’s file
3. Written Explanation Created by Your Firm Now
   • A memo can be written now documenting support for the selected testing item. This is only acceptable if the person writing the memo has knowledge of the issue that can be documented to support the testing (e.g., a recollection of a verbal request from the client that was never documented) and if the other items above are not available. This should only be used in rare occasions as a last resort.

The following sections discuss each of the most common testing areas in more detail.

The purpose of membership testing is to confirm that portfolios are included in the correct composite for the correct time period, as determined by your firm’s GIPS policies and procedures. It is important to remember that any movement in and out of composites should always tie back to policies outlined in your firm’s GIPS policies and procedures and should not be made based on discretionary changes to a portfolio made by the portfolio manager. For the GIPS standards, the consistent application of policies is key!

Membership Testing

Entry Testing

The purpose of entry testing is to confirm that your firm has consistently followed your stated membership policies and procedures for including portfolios in composites. The verifier’s testing approach is adjusted to match your documented policies and procedures for portfolios entering a composite. Portfolio inclusion is typically triggered due to one of the following reasons:

1. New portfolio opened
2. Portfolio increased in size and now meets the minimum asset level of the composite
3. Material restriction was removed from the portfolio
4. Re-inclusion of a portfolio following a significant cash flow

When pulling supporting documents for the verifier, it is important to consider the reason the portfolio entered (or re-entered) the composite. When providing supporting documents, make sure the documents demonstrate the reason for inclusion and provide additional written commentary when necessary to help the verifier gain a full understanding of the situation. This will speed up the verification process as it will cut down on the need for follow-up questions.

In testing that your firm has consistently followed your stated membership policies and procedures for including portfolios in composites, the verifier is primarily focused on the timing and placement of portfolios entering a composite. Testing timing involves the verifier confirming your stated policy is being followed in terms of when the portfolio should enter the composite. Testing placement involves the verifier confirming that the portfolio is added to a composite that aligns with the portfolio’s investment objective.

To confirm the timing of a new portfolio’s inclusion, the verifier typically requests several documents, most commonly the account’s transaction summary and contract. The transaction summary provides information about when the new portfolio was funded, and when the portfolio manager started investing in discretionary assets. The contract is used to assess when the discretionary contract was signed by your client and ensure the timeline makes sense.

Placement can be a bit more complicated in terms of support. The verifier typically requests several standard documents to support the placement. This is not an all-inclusive list, but items requested to support placement can include contracts, investment policy statements, portfolio holdings, fee schedules, client correspondence, CRM system notes, and/or internal memos.

Exit Testing

Opposite of entry testing, exit testing is the verifier’s testing of portfolios that leave a composite. Before diving into the documents your verifier may request, it’s best to figure out why the selected portfolio is exiting the composite. This background knowledge will help you focus on the type of documentation to provide your verifier.

Because portfolios selected for exit testing are not joining a composite, there is no placement considerations in this testing like there is for entry testing. Therefore, exit testing focuses on the timing of a portfolio’s removal from the composite and ensuring the reason for removal is valid. Whether the account lost discretion, terminated, changed its mandate, or violated a composite-specific policy, the verifier will be looking to test the timing of the event.

The most common types of documentation that can support the removal include updated contracts, client correspondence, internal memos, and transaction summaries. The transaction summary will show the true timing of the change to the portfolio, but when discretion is lost or a mandate is changed the verifier will also be looking for support that this change was client driven, which cannot be supported by a transaction summary alone.

It is important to note that unless a composite is redefined or a composite policy is broken (such as the portfolio dropping below a minimum asset level) any movement of portfolios in or out of composites must be client-driven. That is, support for a portfolio exiting a composite should include documentation of a client requesting to terminate management, change the strategy, or add some kind of material restriction.

For example, a client request to hold high levels of cash because of declining market conditions may be a reason to remove the portfolio from the composite, if holding such cash moves the account to non-discretionary status (as outlined in your GIPS policies & procedures). Alternatively, if a portfolio manager used their discretion to deviate from the documented composite description (e.g., holding higher cash levels than described in its strategy due to adverse market conditions), this is not considered a valid reason to remove a portfolio from the composite.

Another form of membership testing is outlier testing. In this analysis, instead of evaluating the movement of portfolios in or out of a composite, the verifier assesses portfolios with performance that deviates from its peers. The purpose of this testing is to confirm that the portfolio is correctly included in the composite, despite the difference in performance.

Outlier Testing

Performance deviations can happen for several reasons and are not necessarily a problem. For example, the following are a handful of common reasons for performance deviations:

1. A portfolio may have a large cash flow causing a temporary deviation. This is especially true for composites that do not have a significant cash flow policy
2. A portfolio may contain different holdings than others in the composite, despite having the same objective
3. Sometimes smaller portfolios may be more concentrated than larger portfolios (most commonly seen when the composite does not have a minimum asset level)
4. A portfolio may be subject to client-mandated restrictions that the firm has deemed immaterial to the implementation of the strategy

The verifier will want to gain comfort that the investment mandate for the portfolio is in line with the composite strategy, any client-mandated restrictions are not material enough for the portfolio to be considered non-discretionary, and no composite policies have been broken relating to minimum asset levels, significant cash flows, etc. In these situations, an explanation should be provided to the verifier to help them understand why the portfolio belongs in the composite, despite having different performance for the month tested.

Please note that if a portfolio is performing differently than its peers because of a restriction, the verifier will want to confirm that the restriction is client-mandated and that it is not breaking any rules outlined in your firm's definition of discretion within your GIPS policies & procedures. If the restriction is material and breaks your firm’s rules for discretion, then the portfolio should not be in the composite and will need to be removed.

Non-Discretionary Testing

While membership testing focuses on portfolios in (or moving in and out of) composites, non-discretionary testing focuses on confirming that portfolios not in composites have a valid reason to be excluded.

Unless a portfolio is deemed non-discretionary, all fee-paying segregated accounts must be included in a composite. Any account excluded from all composites should have a client-driven reason for the exclusion (e.g., a material restriction or a request for a custom mandate). As mentioned, deviations from the strategy made by the portfolio manager’s discretion are not valid reasons to exclude accounts from composites.

The verifier’s sample of non-discretionary portfolios will come directly from your AUM report or list of non-discretionary portfolios. The verifier is typically looking for non-discretionary portfolios they have never tested (many verification firms track portfolios they have tested in prior years), larger non-discretionary portfolios, and non-discretionary portfolios with unique/different reasons listed for being excluded. Because the list of non-discretionary portfolios is a snap shot in time, it will likely include many exclusion reasons– whether it is a long-term restriction, short-term restriction, or a violation of composite policies like a minimum asset level or a significant cash flow policy.

In addition to providing the reason the portfolio is non-discretionary, common requests from a verifier include contracts, investment policy statements and portfolio holdings reports. Verifiers use contracts and investment policy statements to find any documented restrictions in the paperwork. Often, this is clearly outlined in these onboarding documents, but this is not always the case. If restrictions are not clearly documented in these files, the verifier will likely request CRM notes, email correspondence with the client, and/or an internal memo to document the restriction in place. A portfolio-holdings report typically is used to see if any noted restriction is evident in the holdings and management of the account.

Portfolio-Level Return Testing

There are two main goals of portfolio-level return testing:

1. Confirmation that the input data used in the calculation can be independently supported
2. Verification that the calculation methodology outlined in the firm’s GIPS policies and procedures can be applied to the input data to achieve materially the same performance result as your firm

For a firm-wide verification, verifiers will likely have you provide a sample of custodial records in addition to portfolio accounting system reports to gain comfort that the input data used in the performance calculations can be independently supported. If you are having a performance examination on a composite in addition to the firm-wide verification, then this sample will likely be greatly increased.

The verifier uses the portfolio’s custodial statement in conjunction with the corresponding system holdings report and transaction summary to confirm whether market values and transaction activity, including trades, cash flows, fees and expenses, match between the two documents. If there are differences in the timing or amounts of transactions, the verifier will likely have follow-up questions to gain and understanding as to why such differences exist. Lastly, the custodial statement can also be used to confirm whether the portfolio is paying commissions on a per-trade basis.

The portfolio’s fee schedule may also be requested. If the composite calculates net-of-fee returns using actual investment management fees, the verifier will look at the portfolio’s gross and net-of-fee returns to ensure they are in line with the portfolio’s fee schedule. If the spread between gross- and net-of-fee returns does not reconcile with the fee schedule, there will be follow-up questions to figure out why the difference exists and if there are any other fees/expenses impacting the returns that need to be considered.

If your composite net-of-fee returns are calculated with model fees, the verifier will compare the provided fee schedule against the applied model fee. If the model fee is higher than the provided fee schedule, there will likely be no further questions. However, if the fee schedule is higher than the applied model fee, the verifier will likely need to do some alternative testing to ensure that the model fee applied is appropriate.

Once the input data is validated, the verifier will apply the calculation methodology outlined in your firm’s GIPS policies and procedures to confirm they can achieve materially the same performance results. Specifically, the verifier is looking at the treatment of external cash flows, fees, withholdings tax, and interest and dividend accruals to ensure the treatment of each meets the requirements of the GIPS standards and matches your firm’s policies and procedures.

If the verifier is unable to recalculate the returns following the methodology outlined in your GIPS policies and procedures and you believe the timing and amount of all transactions are consistent between your system and what the verifier is using, you should double check that your policies accurately describe your current system settings. For example, have you accurately documented whether external cash flows are accounted for as of the beginning of day or end of day, whether dividends are accounted for as of ex-date or payment date, whether performance is reduced by withholdings taxes, what size cash flows trigger revaluation, or any other settings that could trigger a difference in the performance calculation?

This is an important part of the verification testing as it confirms that an appropriate calculation methodology, acceptable under the requirements of the GIPS standards, has been consistently applied to the portfolios across your firm. Any material differences identified in this testing will need to be resolved before the verification can be completed.

Wrapping up the Verification

Once all testing procedures are complete, most verification firms will conduct their own internal quality control review to ensure the engagement team adequately addressed all testing items before officially signing-off. During this review some additional questions may arise to satisfy the reviewer, but the testing should be materially complete at this point. It is helpful if you can be prepared to answer questions and provide any last-minute document requests in a timely fashion to help move the project across the finish line.

Once all internal reviews have been completed and signed off, the verifier will send a representation letter to your firm. The representation letter is essentially a request for your firm’s attestation that, to the best of your knowledge, everything provided during the verification was accurate and complete. This is a necessary step that all verification firms require you to complete before the verification opinion letter can be issued.

After the representations letter has been attested to by your firm, the opinion letter should be issued shortly thereafter. This wraps up your verification project. Time to celebrate with your team and hopefully enjoy a bit of time away from the verification project before the next annual project begins.

One final recommendation is to have a debrief with your team and any consultants you work with to maintain GIPS compliance. Discuss what went well and what areas held up the verification project. If any areas held up the timeline, this is a good opportunity to consider ways to improve procedures and ongoing composite/data reviews. Planning ahead and implementing improved processes based on what was learned during the verification will help future verifications continue to get smoother over time.

Conclusion

The challenges faced when going through a GIPS verification can vary depending on your firm’s structure/size, the types of products you manage, and the verification firm used. This series was intended to provide a general overview of the most typical verification process and share tips and tricks for helping simplify your verification. If you have questions unique to your verification that we did not cover, please reach out to us to learn more. If you need assistance with a GIPS compliance, Longs Peak is here to help. We have helped hundreds of firms become GIPS complaint and maintain that compliance on an ongoing basis. We are happy to assist your firm with all of its needs relating to the calculation and presentation of investment performance.

You can email matt@longspeakadvisory.com or sean@longpseakadvisory.com with questions or check out our website for more information.