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Investment firms and asset owners that comply with the GIPS standards are required to make some modifications to their GIPS Reports (formerly known as “GIPS compliant presentations”) to address changes made to the 2020 edition of the Standards. The extent of these updates depends on:

1. Whether your organization plans to adopt any new optional policies (e.g., carve-outs, estimated transaction costs, etc.)
2. If your organization plans to change any calculation methodologies now allowed under the new standards (e.g., switching from time-weighted returns to money-weighted returns where allowable)
3. Whether your organization manages pooled funds, separate accounts, or both.

The change of the report name from compliant presentations to GIPS Reports happened as a result of a reorganization of the standards to address the differences between separate account managers, pooled fund managers and asset owners. Depending on your organization, you could have GIPS Composite Reports, GIPS Pooled Fund Reports, and/or GIPS Asset Owner Reports.

Nevertheless, GIPS Report updates are required for all compliant organizations. The updates involve more than changing the name of the document and can vary significantly based on the organization. In this article we focus only on the changes required for organizations already complying with the 2010 edition of the GIPS standards; however, a complete checklist of Required GIPS Report Disclosures for Firms, covering all disclosures required for firms under the 2020 edition of the GIPS standards is available for download. In addition, a checklist of required disclosures for 2020 GIPS Advertisements is also available for download.

Deadline to Update GIPS Reports

Beyond updating the GIPS Reports for disclosures and statistics, organizations must now be able to update these reports with performance information in a timely fashion. Previously there was no set deadline on when a GIPS Report needed to be updated. Organizations are now required to have their GIPS Reports updated within 12 months after each year end. That means that if your firm presents performance for a standard calendar year, by 31 December 2021 all GIPS compliant organizations are required to have their GIPS Reports updated with 2020 performance statistics and related disclosures.

Many firms prefer to wait until their verification is complete before distributing updated GIPS Reports. This is not required, nor is it recommended, but it can help firms avoid material errors in their performance. Firms that prefer to do this will need to ensure their verification is complete within 12 months after each year end. If your firm needs help making sure this work is completed and your GIPS Reports are updated on time, Longs Peak is available to support your process to get this done.

Minimum Updates Required for GIPS Composite Reports (Formerly Compliant Presentations)

GIPS Composite Reports are the same as what was known as GIPS compliant presentations under 2010 GIPS; however, all firms are required to change the following:

1.  Edit the wording for the claim of compliance as it has changed for 2020. This disclosure is required to be word-for-word and the wording depends on whether your firm has been verified and if a performance examination was conducted for the composite. Below is the exact wording firms must use:

For firms that are verified

“[Insert name of FIRM] claims compliance with the Global Investment Performance Standards (GIPS®) and has prepared and presented this report in compliance with the GIPS standards. [Insert name of FIRM] has been independently verified for the periods [Insert dates]. The verification report(s) is/are available upon request.

A firm that claims compliance with the GIPS standards must establish policies and procedures for complying with all the applicable requirements of the GIPS standards. Verification provides assurance on 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. Verification does not provide assurance on the accuracy of any specific performance report.”

For composites of a verified firm that have also had a performance examination:

“[Insert name of FIRM] claims compliance with the Global Investment Performance Standards (GIPS®) and has prepared and presented this report in compliance with the GIPS standards. [Insert name of FIRM] has been independently verified for the periods [Insert dates].

A firm that claims compliance with the GIPS standards must establish policies and procedures for complying with all the applicable requirements of the GIPS standards. Verification provides assurance on 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. The [insert name of COMPOSITE] has had a performance examination for the periods [insert dates]. The verification and performance examination reports are available upon request.”

For firms that have not been verified:

This did not change in 2020 and should still be disclosded as:

“[Insert name of FIRM] claims compliance with the Global Investment Performance Standards (GIPS®) and has prepared and presented this report in compliance with the GIPS standards.  [Insert name of Firm] has not been independently verified.”

2.  Add the newly required trademark disclosure, which must be disclosed word-for-word as, “GIPS® is a registered trademark of CFA Institute. CFA Institute does not endorse or promote this organization, nor does it warrant the accuracy or quality of the content contained herein.”

3.  Add the composite’s inception date.

4.  If the composite contains a pooled fund and the firm elects to present prospective pooled fund investors with the GIPS Composite Report rather than a GIPS Pooled Fund Report (discussed later), the fee schedule disclosed must be that of the pooled fund and is required to include the total pooled fund expense ratio.

5.  If the firm manages limited distribution pooled funds, the firm must disclose the availability of a list of descriptions of their limited distribution pooled funds. If the firm manages broad distribution pooled funds, the firm must disclose the availability of a list of the names of the broad distribution pooled funds the firm manages.

6.  Edit the disclosure previously required about policies for valuing portfolios, calculating performance, and preparing compliant presentations to refer to valuing “investments” instead of valuing “portfolios” and preparing “GIPS Reports” instead of “compliant presentations.” Specifically, that disclosure should now state (emphasis added for clarity), “Policies for valuing investments, calculating performance, and preparing GIPS Reports are available upon request.”

7.  If a custom benchmark is used, such as a blended benchmark, the benchmark must clearly be labeled and disclosed as a “custom benchmark.”

8.  If not already clearly disclosed, firms are required to indicate whether 3-year annualized ex post standard deviation and dispersion were calculated using gross-of-fee returns or net-of-fee returns. If other risk measures are presented, this must be disclosed for all risk measures.

2020 GIPS Report Changes for Firms with Pooled Funds

Under the 2010 GIPS standards, firms were required to provide GIPS compliant presentations to all prospective clients, as defined in the firm’s GIPS policies and procedures. While not perfectly clear, many firms interpreted this to mean all prospective separate account investors that were interested in opening a separate account that would be eligible for composite inclusion.

The 2020 edition of the GIPS standards clarifies how GIPS applies when marketing to prospective pooled fund investors. Firms are not required to provide GIPS Reports to prospective investors in “Broad Distribution Pooled Funds,” such as mutual funds, but firms are required to provide GIPS Reports to prospective investors in “Limited Distribution Pooled Funds,” such as private funds set up as limited partnerships.

Prospective investors in a limited distribution pooled fund must be provided with one of the following:

• GIPS Composite Report – This is for the composite in which the pooled fund is included. As mentioned in item 4 above, the fee disclosures must be modified to describe the fees of the fund rather than just the management fee that would normally be presented for separate account prospects of the composite. In the GIPS Composite Report, firms can either include both the management fee information for separate account prospects and the fund fee information for pooled fund prospects or two separate versions of the GIPS Composite Report can be maintained, 1) for use with separate account prospects describing the applicable management fees and 2) for pooled fund prospects describing the total fund expenses.

• GIPS Pooled Fund Report – When marketing to pooled fund prospective investors, a new alternative to using a GIPS Composite Report is to create a GIPS Pooled Fund Report. This report is very similar to a GIPS Composite Report, but it describes the details of the actual fund instead of more broadly describing the strategy as done previously in a GIPS Composite Report. All disclosures and statistics are the same as a GIPS Composite Report, except for the following modifications:
  • Returns are for the fund itself rather than for a composite of similarly managed portfolios.
  • If net-of-fee returns are presented they must be net of total pooled fund fees, not only transaction costs and management fees.
  • Dispersion and number of portfolios is not presented since the results are for a single fund.
  • The pooled fund description differs from a composite description in that it discusses the actual investment vehicle. Composite descriptions broadly describe the investment objectives and key risks of the strategy without referencing any specific portfolio.

2020 GIPS Report Utilizing Money-Weighted Returns

The 2010 edition of the GIPS standards only allowed the use of money-weighted returns in private equity composites and certain real estate composites where the portfolio manager controlled the timing and amount of external cash flows. The 2020 edition of the GIPS standards allows money-weighted returns to be used, regardless of the asset class as long as certain criteria is met. Please see Longs Peak’s article on How to Update your GIPS Policies & Procedures for GIPS 2020 for more information on when using a money-weighted return is acceptable.

When money-weighted returns are utilized, the requirements for statistics and disclosures are very similar to what was previously required for private equity. For example, instead of time-weighted returns, the GIPS Report will include money-weighted returns as well as several statistics and multiples including:

• Cumulative committed capital
• Since-inception paid-in capital
• Since-inception distributions
• Total value to since-inception paid-in capital
• Since-inception distributions to since-inception paid-in capital
• Since-inception paid-in capital to cumulative committed capital
• Residual value to since-inception paid-in capital

Two differences from what was required for private equity composites under the 2010 GIPS standards and what is required in money-weighted GIPS Reports under the 2020 GIPS standards include:

1. Periods presented for statistics – Under the 2010 GIPS standards, private equity composites were required to present returns and other statistics/multiples as of each year-end (e.g., since inception money-weighted returns were presented from inception through the end of each calendar year). The 2020 GIPS standards only require the returns and other figures to be presented through the latest period end (e.g., since inception money-weighted returns are only required to be presented from inception through the end of the most recent period).
2. Subscription line of credit – When a subscription line of credit is used, the money-weighted return must be presented both with and without the subscription line of credit unless:
   • The principal was repaid within 120 days using called capital and
   • No principal from the line of credit was used to fund distributions.

If these two criteria are met, then the money-weighted return may be presented in the GIPS Report without the subscription line of credit.

In cases where firms must present money-weighted returns both with and without the subscription line of credit, firms must disclose:

1. The purpose for using the subscription line of credit.
2. The size of the subscription line of credit as of the end of the most recent annual period.
3. The amount outstanding on the subscription line of credit as of the end of the most recent annual period.

Additionally, if your firm was not using daily cash flows prior to 1 January 2020, you must disclose the frequency that was used (e.g., monthly or quarterly). Daily cash flows are required for periods beginning 1 January 2020.

2020 GIPS Report Changes for Asset Owners

Asset Owners are required to report time-weighted returns for each total fund. In addition to reporting the time weighted returns for each individual total fund, asset owners have the option of creating composites. Composites can be created to present asset class performance or an aggregation of multiple total funds with similar mandates. For these optional composites, asset owners may present time-weighted returns, money-weighted returns, or both.

GIPS Asset Owner Reports for total funds are very similar to the GIPS Pooled Fund Reports created by firms with the following modifications:

• Net-of-fee returns must be included and must be net of:
  • transaction costs,
  • all fees and expenses (for externally managed pooled funds),
  • investment management fees (for externally managed segregated accounts), and
  • investment management costs.

Unlike firms that charge a management fee, investment management costs for asset owners include all costs involved in managing the assets including general overhead costs of the investment management function of the asset owner.

2020 GIPS Report Changes for other Optional Policies

As discussed in Longs Peak’s article on How to Update your GIPS Policies & Procedures for GIPS 2020, the updated standards introduce some optional policies firms may elect to adopt. If the following are utilized, disclosures must be updated as described.

Carve-outs – If a composite includes carve-outs with allocated cash, the composite must include “carve-out” in the composite name. This carve-out composite must disclose that the composite includes carve-outs with allocated cash along with a description of how the cash is allocated and the percentage of the composite comprised of carve-outs as of each year end. If the firm also has a composite of standalone portfolios following the same strategy, the annual performance and annual assets of the standalone composite must also be presented with the carve-out composite and a disclosure must be included explaining that the GIPS Report for the composite of standalone portfolios is available upon request.

Estimated Transaction Costs – Historically, only actual transaction costs could be used to reduce returns. Because of this, wrap or other bundled fee accounts (where transaction costs could not be clearly identified) were unable to present a gross-of-fee return. Instead, a pure gross-of-fee return was generally presented, which needed to be labelled as supplemental information. The 2020 GIPS standards now allow the use of estimated transaction costs in cases where actual transaction costs cannot be identified. If estimated transaction costs are used, firms must disclose how the estimated transaction costs are determined.

Model Management Fees – The ability to use model investment management fees to calculate net-of-fee returns is not new, but there is a new disclosure requirement to describe the methodology used to determine the net-of-fee returns using the model fee. Also, under the 2010 edition of the GIPS standards firms were required to disclose the percentage of the composite comprised of non-fee-paying portfolios. Under the 2020 GIPS standards this is still required for composites that present net-of-fee returns using actual fees but is no longer required for composites utilizing model fees to calculate net-of-fee returns.

Advisory-Only Assets – As more firms move strategies to UMA platforms and other similar arrangements where one firm provides trades for another firm to implement, the 2020 GIPS standards now provide guidance on how these assets may be reported. Historically, most firms excluded these assets when reporting total firm assets, but the guidance was not clear so some firms were including these assets in their total firm assets. The 2020 GIPS standards now clearly state that these assets must be excluded from total firm assets, but they do provide guidance on how these assets can also be reported for firms that choose to do so.

In addition to the official total firm assets that excludes advisory-only assets, firms can choose to also present advisory-only assets or a combination of total firm assets and advisory-only assets. Either option must be clearly labelled to explain what is presented. The same can be done for composite assets. Firms must present the actual composite assets and then may also present the advisory-only assets following the strategy or a combination of the composite assets and advisory-only assets together.

Uncalled Committed Capital – Similar to advisory-only assets described above, private fund managers with committed capital cannot include uncalled committed capital when reporting pooled fund assets and total firm assets. Only the current fair value of the fund or firm’s assets can be presented as the fund or total firm assets. But many firms wish to present the amount of uncalled committed capital they have subscribed to their funds.

The 2020 GIPS standards now provide clear guidance on how uncalled committed capital can be shown. At the pooled fund level, it can be combined with the pooled fund assets or it can be shown separately. At the total firm level, it also can be combined with total firm assets or shown separately. Whichever option is chosen, it must be clearly labelled to explain what it represents. To be clear, the official total firm or pooled fund assets must still be disclosed excluding uncalled committed capital. These options to present uncalled committed capital are only allowed in addition to, not instead of this required statistic.

Disclosure Sunset Provisions – Historically, there was no guidance that allowed firms to remove disclosures. The 2020 GIPS standards now specify certain disclosures that can be removed after one year as long as the firm feels the disclosures are no longer necessary for a user of the report to be able to interpret the information presented. Examples of what may now be removed after one year include disclosures regarding:

• Significant events
• Composite name changes
• Retroactive benchmark changes
• Material errors
• Changes in return type (e.g., change from reporting TWR to MWR)

Questions?

If you have a situation that we didn’t cover here that is specific to your firm or for more information on GIPS Reports, the changes to the GIPS standards for 2020, or GIPS compliance in general, contact Matt Deatherage at matt@longspeakadvisory.com or Sean Gilligan at sean@longspeakadvisory.com.

The Sortino Ratio is similar to the Sharpe Ratio as it is used to compare and rank managers with similar strategies. However, unlike Sharpe, the Sortino Ratio measures the incremental average strategy return over a minimum acceptable return per unit of downside risk rather than total risk.

Because of this difference, the Sortino Ratio may be more appropriate than the Sharpe Ratio when assessing strategies with non-normal return streams. For example, the Sharpe Ratio is appropriate when assessing a traditional equity manager, while the Sortino Ratio would be more appropriate for a hedge fund strategy that uses derivatives to seek asymmetrical, positive spikes in performance. The Sharpe Ratio, using total risk (measured by standard deviation), would penalize this hedge fund manager for these positive spikes in performance, while the Sortino Ratio, using downside risk (measured by downside deviation), would not.

Sortino Ratio Formula

Annualized Sortino Ratio

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

What is a Good Sortino Ratio?

The Sortino Ratio is a ranking device so a portfolio’s Sortino Ratio should be compared to that of other portfolios rather than evaluated independently. In general, investors prefer higher Sortino Ratios when comparing similarly managed portfolios.

Sortino Ratio vs. Sharpe Ratio Calculation Example

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

Please note that the Sortino Ratio calculated in this example is based on monthly data and, therefore, must be annualized to get the final result. The following is a breakdown of the calculation:

For more details on how to calculate the Sharpe Ratio, check out What is the Sharpe Ratio.

Although the strategies have the same average monthly return over the one-year period, the Sortino Ratios differ significantly due to their differences in downside risk (i.e., downside deviation). Strategy A is preferred over Strategy B to an investor deciding between the two because it has a higher Sortino Ratio.

When using the Sharpe Ratio to evaluate the two strategies, the result is the opposite than it is when using the Sortino Ratio. How can this be?

If the Standard Deviation (i.e., total risk) is higher for Strategy A than Strategy B, but Downside Deviation (i.e., downside risk) is lower for Strategy A than Strategy B, we can infer that at least some of the volatility in Strategy A’s return stream is caused by positive spikes in performance. Standard Deviation treats all volatility (both positive and negative) equally, while Downside Deviation does not penalize the manager for positive volatility.

Sortino Ratio Interpretation

The Sortino Ratio is one of the best measures for return streams with non-normal distributions (such as hedge funds). This is because Sortino only penalizes for negative volatility and not positive spikes in performance.

If, for example, an investor is looking for a high reward strategy, then upside volatility can be a good thing.

Why is the Sortino Ratio Important?

The Sortino Ratio allows investors to evaluate portfolio performance for non-normal return distributions after adjusting for risk. Comparing returns without accounting for risk does not provide a complete picture of the strategy. Using total risk, as the Sharpe Ratio does, can make a strategy look riskier than it truly is if the volatility is skewed positively.

Sortino Ratio Calculation: Using Arithmetic Mean or Geometric Mean

Because the Sortino Ratio compares return to risk (through downside deviation), we use Arithmetic Mean to calculate the strategy return. Geometric Mean penalizes the return stream for taking on more risk. However, since the Sortino Ratio already accounts for risk in the denominator, using Geometric Mean in the numerator would account for risk twice. For more information on the use of arithmetic vs. geometric mean for performance appraisal measures, please check out Arithmetic vs Geometric Mean: Which to use in Performance Appraisal.

If you are an investment firm or asset owner that complieswith the GIPS standards you are required to make some modifications to yourGIPS policies and procedures (“P&P”) to address changes made to the 2020edition of the Standards. The extent of these updates depends on:

1. whetheryour organization plans to adopt any new optional policies,
2. whetheryou have pooled funds to add to the current list of composites, or
3. ifyour organization plans to change any calculation methodologies now allowedunder the new standards.

Like other GIPS requirements, consistent application andadequate documentation are critical to ensuring these updates and changes areapplied correctly and consistently.

GIPS 2020: Minimum Requirements for all GIPSCompliant Organizations

There are some required GIPS policies & procedure updatesthat will impact all organizations claiming compliance. At a minimum, all firmsand asset owners must address the following in their P&P:

Terminology

What was previously called “Compliant Presentations” are nowcalled “GIPS Reports” in the 2020 GIPS standards. Likely, the term “CompliantPresentations” is used throughout your P&P, which needs to be replaced with“GIPS Reports” to be in sync with the language of the updated standards.

Demonstrate that GIPS Reports are Distributed

It has always been a good idea to maintain a log documentingthe distribution of GIPS Reports to help support that your firm met therequirement of providing them to prospective clients; however, it was notpreviously required. The 2020 edition of the GIPS standards now requires firmsto demonstrate how it made every reasonable effort to provide a GIPS Report toprospective clients that are required to receive one.

The most common way to do this is by maintaining a log of thedistribution in a spreadsheet or by noting the distribution in your firm’s CRMsystem. If noting distribution in your CRM, it is important to populate this ina way that can easily be extracted into a report. Your GIPS verifier is nowrequired to test this so you will need to be able to produce a report demonstratingthat your firm is distributing GIPS Reports to prospective clients.

In addition, you must now update your P&P to document theprocess for how this is maintained. Although each firm will need to documentthis differently to accurately describe their process (i.e., the system inwhich it is maintained and who is responsible for maintaining it), below is anexample of how this may be documented:

Each time a GIPS Report is distributed, the firm’s SalesAssociate is responsible for logging the distribution on the firm’s CRM system.This documentation will include who received the GIPS Report, the version ofthe GIPS Report they received, the method of delivery, and the date it wasdelivered. This information may be extracted from the CRM system by the SalesAssociate if requested by a verifier, regulator, or if needed internally.

Error Correction Procedures

In the 2010 edition of the GIPS standards, if a material errorwas discovered in a compliant presentation, correction and redistribution wasrequired with a disclosure of the change to “all prospective clients and otherparties that received the erroneous compliant presentation.” In addition tothese, the 2020 GIPS standards specifically call out providing corrected GIPSReports to your current GIPS verifier as well as any former verifier or currentclient that received the GIPS Report containing the material error.

Currently, most firms’ policies relating to material errors arelikely limited to the action they take to redistribute to current prospectiveclients. We recommend updating this language to specifically address the needto provide the corrected presentation to verifiers and clients who received theerroneous presentation as well. An example of how this may be documented isprovided below:

Our firm willdetermine an identified error is material if the error exceeds the materialitythresholds stated in the Error Correction Policy: Materiality Grid. If thisoccurs, we will correct all affected GIPS Reports, include a disclosure of thechange, and make every reasonable effort to provide a corrected GIPS Report to:

• Prospective clients that received the GIPS Reportthat had the material error;
  • Clients and any former verifiers that received theGIPS Report that had the material error; and
  • Current GIPS verifier.

Verifier Independence

Verifiers are prohibited from testing their own work and,therefore, cannot help their clients by writing policies, calculatingperformance, creating GIPS Reports, etc. To help ensure this independence ismaintained, firms that are verified are now required to gain an understandingof their verifier’s policies for maintaining independence and to consider theirverifier’s assessment of independence to ensure there are no conflicts.

To comply with this, firms must request that their verifierprovide documentation describing the measures they take during the verificationprocess to ensure independence is maintained. The procedures for requesting andassessing this needs to be described in the firm’s GIPS policies &procedures. Below is an example of what this might look like:

Our firm has engaged XYZ Verification Firm as anindependent third-party verification firm to verify our claim ofcompliance. Each year, prior to the start of the annual verification, werequest the independence policy statement from the verification firm.  If there are no changes from the prior year,this confirmation is requested in writing. Any potential threats to independence, either in fact or in appearance,are discussed with the verifier to resolve immediately.

GIPS Report Updates

We will discuss all the changes relating to GIPS Reports in aseparate blog; however, some of those changes will require updates to yourfirm’s GIPS policies and procedures, which we do want to discuss here.Presenting annual internal dispersion and three-year annualized ex poststandard deviation is not new; however, it is new that firms are required todisclose whether gross-of-fee or net-of-fee returns are used in thesecalculations. We recommend adding language to your P&P that makes it clearwhether you will use gross-of-fee or net-of-fee returns. Including this in yourP&P will help you ensure the calculation is consistent with the disclosureyou will be adding to your GIPS Reports. An example of how this could be wordedis as follows:

Composite internal dispersion is measured using theasset-weighted standard deviation of annual gross-of-fee returns of thoseportfolios included in the composite for the full year. The three-yearannualized ex post standard deviation measures the variability of the compositegross-of-fee returns and benchmark returns over the preceding 36-month period.

While either gross-of-fee or net-of-fee returns areacceptable, at Longs Peak we generally recommend that our clients usegross-of-fee returns so the presented volatility relates specifically to the implementationof the strategy and is not affected by management fees (which may differ byaccount, be paid at different times, etc).

Additionally, there is a new requirement to update GIPSReports with the prior year’s information within 12 months of the periodending. In other words, statistics for the period ending December 31, 2020 mustbe added to your GIPS Reports by December 31, 2021.That will be plenty of timefor most firms, but to ensure this is done, we recommend adding a procedure toyour P&P document simply explaining that the reports must be updated within12 months after the end of each annual period.

GIPS 2020: Changes for Firms with Pooled Funds

Firms that have pooled funds willhave a few additional changes to make to their GIPS policies & procedures.

Terminology

Most firms will have language intheir P&P referring to “prospective clients.” In the 2020 GIPS standards,the term prospective client refers specifically to a prospective separateaccount investor while the term “prospective investor” is used when referringto a prospective pooled fund investor. Firms need to review their P&P language and make updates to defineboth terms and ensure they are using the appropriate term depending on thecontext of what is being described.

List of Pooled Funds

Firms have always been required to maintain a list ofcomposite descriptions, but now the same is needed for each pooled fund thefirm manages. For each limited distribution pooled fund, a description needs tobe included (similar to what was done historically for composites). Broaddistribution pooled funds need to be listed, but no description is required.

If you are unsure whether a pooled fund is considered broaddistribution or limited, broad distribution pooled funds are defined in theglossary of the 2020 GIPS standards as “A pooled fund that is regulated under aframework that would permit the general public to purchase or hold the pooledfund’s shares and is not exclusively offered in one-on-one presentations.Limited distribution pooled funds are simply defined as any pooled fund thatdoes not meet the definition of a broad distribution pooled fund.

Pooled Fund Inception Date

Pooled fund performance must be reported back to the pooledfund’s inception date. How the inception date was determined must be documentedin the firm’s GIPS policies & procedures. Inception date could be based onwhen investment management fees are first charged, when the firstinvestment-related cash flow takes place, when the first capital call is made,or when committed capital is closed and legally binding. Whatever criteria isused to determine the inception date must be clearly described in the P&Pto ensure an appropriate inception date is used for each pooled fund managed bythe firm.

Error Correction Thresholds

If language used to document error correction materialitythresholds is specific to composites, this will need to be modified toincorporate thresholds for statistics reported in GIPS Pooled Fund Reports aswell. If the same thresholds are appropriate for both composites and pooledfunds (e.g. composite and pooled fund performance can have the same thresholdand composite and pooled fund assets can have the same threshold) then this maybe as simple as changing “Composite” to “Composite/Pooled Fund” throughout thissection.

Additionally, if your firm is now presenting money-weightedreturns and other related multiples for closed-end funds, you will need to addthresholds to your policy for these statistics as well.

Changes for other Optional Policies

The 2020 GIPS standards offer some more flexibility to ensure theyare as meaningful and useful as possible to all types of investment firms andasset owners. If any of these policies are utilized, additional changes will berequired to describe their use in your firm’s GIPS policies & procedures.Examples of these optional policies include, but are not limited to:

Carve-Outs

If a firm decides to utilize carve-outs with allocated cash,the new carve-out composite will need to be documented in the current list ofcomposites. In addition, the firm will need to implement policies andprocedures as to how they allocate cash, how they identify appropriate assetbuckets to carve-out from existing accounts, which accounts have asset groupsthat need to be carved-out to meet the new composite definition, and documentother composite related policies applied to the carve-out composite.

Portability

Historically, GIPS compliant firms meeting the portabilityrequirements were required to link the historical performance record to theongoing performance. The 2020 GIPS standards change this to make linkingoptional. When portable track records exist, firms need to document in theirP&P 1) whether the historical track record meets the GIPS portabilityrequirements and 2) whether they are electing to link the historicalperformance record or choosing to not link it.

Estimated Transaction Costs

The GIPS standards define “gross-of-fees” as the return oninvestments reduced by transaction costs. Historically, firms complying withthe GIPS standards were prohibited from estimating transaction costs; the useof actual transaction costs was required. The 2020 GIPS standards nowallow estimated transaction costs to be used in cases where actual transactioncosts are not known.

Using actual transaction costs is straightforward fortraditional portfolios that pay transaction costs in the form of commissions oneach trade. The issue most commonly arises with wrap accounts that paytransaction costs as part of a bundled fee.

Historically, firms were not able to present returnsgross-of-fees for their composites containing wrap accounts because they wereunable to determine the actual transaction costs. Most firms instead present“pure gross” returns, which are gross of the entire wrap fee and are requiredto be labelled as supplemental information.

Allowing estimated transaction costs will give firms managingwrap accounts the option to estimate the portion of the wrap fee that is for transactioncosts and reduce returns by this estimated figure.

If estimated transaction costs are utilized, the firm mustdisclose in their GIPS Reports how these estimated transaction costs aredetermined. Similarly, the process used to determine the estimated transactioncosts and the methodology utilized to reduce the returns by the estimatedtransaction costs needs to be documented in the firm’s P&P.

Model Management Fees

Previously, GIPS compliant firms using model investmentmanagement fees (rather than actual fees) to determine net-of-fee results wererequired to use the highest investment management fee. This was generallyinterpreted as the highest fee from the composite’s fee schedule or the highestfee-paying portfolio in the composite, whichever was higher. In the 2020 GIPSstandards, firms using model management fees are required to use a fee that is“appropriate” to the prospective client. While the model fee doesn’t specificallyhave to be the highest fee, the resulting returns still need to be equal to orlower than the results that would be calculated if actual management fees wereused.

If your P&P already describes using the highest managementfee and you will continue to use the highest fee then no change is needed. Ifyou will implement a new process other than highest fee, then it is importantto update your P&P to describe how the model fee will be determined andapplied. This description needs to include how you will confirm that thenet-of-fee returns using the model fee are not higher than they would be if theactual investment management fees were used.

Presenting Advisory-Only Assets

Firms that have Unified Managed Accounts (“UMA Accounts”) orother similar arrangements where they are simply providing a model to beimplemented by another party generally are not able to include these accountsin their total firm assets. These accounts are considered “advisory-only” becausethe manager is only providing the model and has no responsibility to implementthe strategy or monitor the portfolios on an ongoing basis.

This type of arrangement has become increasingly popular overthe last decade. Given the popularity of these relationships, many firms nowhave a large amount of advisory-only assets that they would like to report.Because of this demand, the 2020 GIPS standards have provided guidanceoutlining the proper way for firms to present these assets separate from theirtotal firm assets. Firms electing to present these assets must make it clearhow they intend to report them in their GIPS Reports.

Historically, many firms documented in their P&P somethinglike, “all accounts deemed to be advisory-only, hypothetical, or model innature are excluded from total firm assets” to make it clear that they were notincluding anything in total firm assets that was prohibited. Firms now electingto separately present advisory-only assets must add an additional statementdescribing how they will be presented. For example, “Some of the firm’sstrategies are offered through UMA platforms on an advisory-only basis. Theseassets are presented separately from the firm’s composite assets and total firmassets and will be labelled ‘Advisory-Only Assets’.”

Presenting Money-Weighted Returns

Historically, time-weighted returns were required with twospecific asset class exceptions: Private Equity and Real Estate (when RealEstate was managed in a Private Equity-like fund). The 2020 GIPS standards havenow removed the asset-class specific requirements. Instead, firms may nowpresent money-weighted returns for any asset class as long as the firm hascontrol over the external cash flows and the composite or pooled fund has atleast one of the following characteristics:

• Closed-end
• Fixed life
• Fixed commitment
• Illiquid investments are significant portion ofstrategy.

For firms meeting this criteria and electing to present money-weightedreturns, the P&P must be updated to 1) note that the criteria was met, 2)indicate the election to present money-weighted returns, and 3) outline themethodology utilized to calculate the money-weighted return and other relatedmultiples that must be presented in conjunction with the money-weighted return.

Other Considerations for GIPS Policies &Procedures

When going through your firm’s GIPS policies & procedures to make the required changes for the 2020 GIPS standards, this is a great opportunity to review the document as a whole to ensure everything is still relevant, applicable and accurate. One of the most common deficiencies regulators write in examinations is that policy and procedure documents do not reflect actual practices of the firm. We recommend a comprehensive review be conducted annually. Check out GIPS Compliance Actions for the New Year for a step-by-step guide to this review .

Questions?

If you have a situation that we didn’t cover here that isspecific to your firm or for more information on GIPS Policies and Procedures,the changes to the GIPS standards for 2020, or GIPS compliance in general,contact Matt Deatherage at matt@longspeakadvisory.comor Sean Gilligan at sean@longspeakadvisory.com.

A new decade is upon us and with the new decade comes a series of new requirements in terms of investment performance reporting for firms and asset owners that elect to claim compliance with the GIPS standards.

Many organizations have elected to adopt the 2020 edition of the GIPS standards early and have already put a solid foundation in place for the updated requirements; however, many organizations have not. The adoption deadline for all compliant organizations is rapidly approaching, so if your organization has not begun this conversion, now is the time to get started.

What is Changing and Why

It has been over a decade since the last edition of the GIPS standards was released, and quite frankly, the industry has changed since 2010. As the industry has evolved, CFA Institute has released a number of Q&A’s, guidance statements, and interpretations on how the changes in the industry impact the standards.

Ten years of updates have resulted in a vast repository of information needed to obtain the guidance required to comply. Having so many different resources for guidance (the 2010 GIPS Handbook, separate guidance statements, the Q&A database, and the GIPS Help Desk) has made managing the requirements of GIPS a pretty daunting task; thus, one of the goals of the 2020 standards is to centralize all of the updates that have come out over the past ten years. The 2020 GIPS standards consolidates many of the concepts previously addressed in guidance statements and Q&A’s, allowing the new provisions and explanation of the provisions to serve as the primary source that firms, asset owners, verifiers, and consultants can look to for guidance.

Additionally, the 2010 standards were heavily focused on composites and the traditional definition of prospective clients. Using this as the main framework is not always applicable to organizations that primarily manage pooled funds or asset owners that do not compete for business or report performance to prospective clients. To address this, CFA Institute set out to make this new edition of the standards more applicable to pooled fund managers and asset owners. These updates were designed to make claiming compliance easier and more relevant for these types of managers, while not creating additional burdens on organizations that are already compliant with GIPS. This goal is evident in the new format of the provisions, which separately focuses on requirements for investment firms, asset owners, and verifiers.

In addition to the separation of pooled funds and composites, the guidance is broader on when organizations may present money-weighted returns instead of time-weighted returns. This change now allows the decision to be based on the investment vehicle structure and who controls the timing and amount of external cash flows, rather than limiting money-weighted returns to certain asset classes. This is a welcomed update in the industry as many organizations were frustrated by requirements to calculate and present time-weighted returns when this type of return was not the most meaningful representation of how they managed their investment strategies.

How the 2020 GIPS Standards are Organized

For ease of use and navigation, the 2020 GIPS standards is broken out into three different groups of tailored provisions – firms, asset owners, and verifiers. Each containing specific requirements and recommendations applicable for that type of organization.

As an organization claiming compliance or working to become compliant for the first time, you will need to determine whether the set of requirements for firms or assets owners is applicable to your claim of compliance. The primary distinguishing factor is whether your organization competes for business and manages external money, or reports to an oversight board and manages internal money. The answer to this determines which set of tailored provisions should be followed and sets the framework for how the standards will apply. 

Where to Start – GIPS Compliance Updates

Regardless of whether you are excited for the updates to the standards, they are coming and will be required for all firms and asset owners claiming compliance with GIPS. The new requirements take effect once your GIPS Reports (formerly called Compliant Presentations) present performance information that is inclusive of the period 31 December 2020.

There is a lot of information available and dissecting everything that has been released can be overwhelming. For organizations that have never claimed compliance, the good news is that the new standards are more applicable and easier to adopt than they were previously.

For most organizations currently claiming compliance, what’s great is that the new standards do not require a lot of changes, rather they mostly provide optional procedures that you may choose to adopt if you find it beneficial to do so. However, some firms will require more work.

At Longs Peak, we have created the following questionnaire designed to help you determine if converting to the 2020 GIPS standards will require more than a few minor tweaks. This list does not include all changes, but includes the top ten material changes that may require a project plan to implement the required changes by the effective date of the 2020 GIPS standards.

Answering “Yes” to any of the following questions means your organization may require more than a few quick tweaks to implement the 2020 changes:

GIPS 2020 Checklist 

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

Although the intent is for the adoption of the standards to be more relevant, many organizations find themselves asking “where do I even begin?” The great news is that you don’t have to figure this all out on your own.

At Longs Peak, we have spent countless hours familiarizing ourselves with the new standards and have helped all of our clients begin to adopt the changes. We know what issues come up and how to navigate the changes required.

As a consultant, we do not have independence requirements like your verifier, so we can actually help you implement many of the 2020 changes required for your organization. If you do not already work with a GIPS consultant, now may be a good time to consider hiring one, especially if you lack the resources needed to get this done by the deadline to convert to the 2020 GIPS standards.

Contact us if you do not wish to read through all of the requirements and recommendations to identify what actions are required for your organization.

Finally, if you would like to read more about what changed and why, we have summarized the main changes to the GIPS standards in GIPS 2020 What’s Changing and What you Should Do.

The recent market volatility probably has you wondering how your strategy has fared through this unprecedented time. Disruptive market environments tend to reveal critical information about active managers that help investors see those that truly add value, and those that don’t. So, what should you do to evaluate your actively-managed strategy and how can you help your clients and prospects understand how your strategy performed during these difficult times? Read on.

Investment Performance in Up-Markets vs Down-Markets

During the long bull market run over the last 10+ years, investment firms have been able to effectively market their actively managed investment strategies with an emphasis on pure performance with little, if any, focus on risk. Consistent outperformance in up-markets is great, but it does not demonstrate how the strategy will react to a market downturn. Risk always goes hand-in-hand with performance and is increasingly important to discuss with clients and prospective clients as we navigate the highly volatile downturn we are currently experiencing.

Statistics used to present the results of actively managed strategies should do more than simply show the returns of the strategy vs. the returns of the benchmark. While returns show us where the strategy and benchmark ended and how much they changed over a stated period of time, they do not show how bumpy the road was to get there.

Investment performance and risk statistics should be used to help tell the story of how your firm actively manages the presented strategy. If your strategy description says that it will outperform in up-markets and provide protection on the downside, you should be presenting performance appraisal measures and risk statistics, such as Jensen’s Alpha, Sharpe ratio, Treynor ratio, up and down-market capture ratios, etc. that back-up those claims.

Types of Investment Risk

When assessing investment risk there are two main risk indicators to look at 1) systematic risk (i.e., market risk) and 2) total risk, which includes both systematic risk and unsystematic risk (i.e., security specific risk).

Systematic Risk Statistics

The most common way to assess the systematic risk of a strategy compared to its benchmark is by looking at the strategy’s beta. Beta measures the sensitivity of a strategy to market movements. If the strategy returns move perfectly in sync with the benchmark return then the strategy’s beta as compared to that benchmark is 1 (i.e., they are perfectly correlated).

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 replicated 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 and underperform on the downside.

To determine if the portfolio manager has “added alpha,” you can calculate Jensen’s alpha for the strategy. Jensen’s alpha measures how much the strategy outperformed its expected return, with the expected return determined based on the risk-free rate plus the beta-adjusted benchmark return. 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.

Demonstrating positive alpha over a sustained period of time demonstrates to clients and prospects of the strategy that the active decisions made by the portfolio manager resulted in an increased return without increasing systematic risk.

Total Risk Statistics

Total risk is generally measured with standard deviation. Standard deviation has become more commonly presented, especially since the 3-year annualized ex-post standard deviation became required for GIPS Reports; however, this information may not be easily understood by readers of a performance report without some explanation.

If your investment strategy has returns that outperformed the benchmark AND has a standard deviation that is lower than the benchmark’s standard deviation, you can emphasize to your clients and prospects that you have outperformed the benchmark while taking less risk to do so (i.e., you had a less bumpy ride than the benchmark to get to your end result).

If your strategy’s returns did not outperform the benchmark, but your standard deviation is lower than that of the benchmark, you still may have outperformed the benchmark when looked at on a risk-adjusted basis. The most common way to assess this is with the Sharpe ratio.

The Sharpe ratio is one of the most popular performance appraisal measures. It measures excess return per unit of total risk. You can easily calculate this by taking your strategy’s average return minus the average risk-free rate and dividing that by the strategy’s standard deviation.

The Sharpe ratio is a ranking device, so the strategy’s Sharpe ratio on its own does not mean much. You should complete the same calculation for the benchmark and compare the two. If your strategy’s Sharpe ratio is higher than the Sharpe ratio of the benchmark then you can explain to your clients and prospects that you outperformed the benchmark on a risk-adjusted basis. For more information on how to calculate the Sharpe Ratio, see our latest blog What is the Sharpe Ratio.

In the volatile markets we are facing at the moment, outperforming the market (or your strategy’s benchmark) on a risk-adjusted basis may be more important than having outright higher returns. With the high volatility we are currently experiencing, returns could be changing significantly every day. The presentation of returns without consideration, discussion, and demonstration of risk only tells one part of the story.

By including risk as a second dimension of performance you will be able to exhibit skill over luck and demonstrate how your strategy is prepared to perform regardless of the market conditions we face over the coming months and years.

Tools to Calculate Risk Statistics

Depending on your strategy, there are a number of other statistics that can help you analyze how your investment performance has fared through the current market conditions. If you would like to calculate some of these measures on your own, please see Longs Peak’s Performance Appraisal Statistics Cheat Sheet for formulas.

In addition, Longs Peak calculates performance appraisal measures and risk statistics for our clients that can be used internally as part of your portfolio management feedback loop, and externally to help demonstrate the success of your active management to clients and prospects. Below are some samples of the reports we create. We would be happy to calculate or discuss any of these statistics with your firm.

Questions? 

If you have questions about investment performance and risk statistics, we would be love to help. Longs Peak’s professionals have extensive experience helping firms with their investment performance needs. We can do anything from providing ad-hoc investment performance calculations to operating as your fully outsourced investment performance team. Please to email Sean Gilligan directly at sean@longspeakadvisory.com for more information.

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

Why Utilize Composites?

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

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

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

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

Why test for performance outliers?

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

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

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

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

How can performance outliers be identified?

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

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

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

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

What to consider when reviewing outlier performance

The severity of the outlier

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

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

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

How often the portfolio is an outlier

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

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

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

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

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

Common causes of outlier performance:

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

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

Ready to implement performance outlier testing at your firm?

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

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

Questions? 

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

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

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

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

Key Questions to Consider

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

Need Help Navigating or Implementing the 2020 GIPS Standards?

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

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

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

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

Why are changes to the GIPS standards necessary?

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

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

What is changing with GIPS?

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

Asset Owners 

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

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

Managers of Pooled Funds 

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

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

Option to present MWR

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

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

Valuation Requirements

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

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

Carve-outs

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

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

Portability

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

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

Advisory-Only Assets

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

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

Deadline to Update GIPS Presentations

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

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

Sunset Provisions for Select Disclosures

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

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

Additional Statistic in GIPS Presentations

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

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

Estimated Transaction Costs

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

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

Revised Advertising Guidelines

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

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

What action should be taken now?

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

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

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

Questions?

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

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

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

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

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

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

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

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

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

Link to fundraiser page: Gilly Does Kili