How to Update your GIPS Policies & Procedures for GIPS 2020

If you are an investment firm or asset owner that complies with the GIPS standards you are required to make some modifications to your GIPS policies and procedures (“P&P”) 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,
  2. whether you have pooled funds to add to the current list of composites, or
  3. if your organization plans to change any calculation methodologies now allowed under the new standards.

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

GIPS 2020: Minimum Requirements for all GIPS Compliant Organizations

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

Terminology

What was previously called “Compliant Presentations” are now called “GIPS Reports” in the 2020 GIPS standards. Likely, the term “Compliant Presentations” 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 documenting the distribution of GIPS Reports to help support that your firm met the requirement of providing them to prospective clients; however, it was not previously required. The 2020 edition of the GIPS standards now requires firms to demonstrate how it made every reasonable effort to provide a GIPS Report to prospective clients that are required to receive one.

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

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

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

Error Correction Procedures

In the 2010 edition of the GIPS standards, if a material error was discovered in a compliant presentation, correction and redistribution was required with a disclosure of the change to “all prospective clients and other parties that received the erroneous compliant presentation.” In addition to these, the 2020 GIPS standards specifically call out providing corrected GIPS Reports to your current GIPS verifier as well as any former verifier or current client that received the GIPS Report containing the material error.

Currently, most firms’ policies relating to material errors are likely limited to the action they take to redistribute to current prospective clients. We recommend updating this language to specifically address the need to provide the corrected presentation to verifiers and clients who received the erroneous presentation as well. An example of how this may be documented is provided below:

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

    • Prospective clients that received the GIPS Report that had the material error;
    • Clients and any former verifiers that received the GIPS 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, calculating performance, creating GIPS Reports, etc. To help ensure this independence is maintained, firms that are verified are now required to gain an understanding of their verifier’s policies for maintaining independence and to consider their verifier’s assessment of independence to ensure there are no conflicts.

To comply with this, firms must request that their verifier provide documentation describing the measures they take during the verification process to ensure independence is maintained. The procedures for requesting and assessing 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 an independent third-party verification firm to verify our claim of compliance. Each year, prior to the start of the annual verification, we request 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 a separate blog; however, some of those changes will require updates to your firm’s GIPS policies and procedures, which we do want to discuss here. Presenting annual internal dispersion and three-year annualized ex post standard deviation is not new; however, it is new that firms are required to disclose whether gross-of-fee or net-of-fee returns are used in these calculations. We recommend adding language to your P&P that makes it clear whether you will use gross-of-fee or net-of-fee returns. Including this in your P&P will help you ensure the calculation is consistent with the disclosure you will be adding to your GIPS Reports. An example of how this could be worded is as follows:

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

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

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

GIPS 2020: Changes for Firms with Pooled Funds

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

Terminology

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

List of Pooled Funds

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

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

Pooled Fund Inception Date

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

Error Correction Thresholds

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

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

Changes for other Optional Policies

The 2020 GIPS standards offer some more flexibility to ensure they are as meaningful and useful as possible to all types of investment firms and asset owners. If any of these policies are utilized, additional changes will be required 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 of composites. In addition, the firm will need to implement policies and procedures as to how they allocate cash, how they identify appropriate asset buckets to carve-out from existing accounts, which accounts have asset groups that need to be carved-out to meet the new composite definition, and document other composite related policies applied to the carve-out composite.

Portability

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

Estimated Transaction Costs

The GIPS standards define “gross-of-fees” as the return on investments reduced by transaction costs. Historically, firms complying with the GIPS standards were prohibited from estimating transaction costs; the use of actual transaction costs was required. The 2020 GIPS standards now allow estimated transaction costs to be used in cases where actual transaction costs are not known.

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

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

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

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

Model Management Fees

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

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

Presenting Advisory-Only Assets

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

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

Historically, many firms documented in their P&P something like, “all accounts deemed to be advisory-only, hypothetical, or model in nature are excluded from total firm assets” to make it clear that they were not including anything in total firm assets that was prohibited. Firms now electing to separately present advisory-only assets must add an additional statement describing how they will be presented. For example, “Some of the firm’s strategies are offered through UMA platforms on an advisory-only basis. These assets are presented separately from the firm’s composite assets and total firm assets and will be labelled ‘Advisory-Only Assets’.”

Presenting Money-Weighted Returns

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

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

For firms meeting this criteria and electing to present money-weighted returns, 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 the methodology utilized to calculate the money-weighted return and other related multiples 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 is specific 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.com or Sean Gilligan at sean@longspeakadvisory.com.

Investment Performance and Risk Statistics

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.

What is the Sharpe Ratio?

The Sharpe Ratio is calculated as the strategy’s mean return minus the mean risk-free rate divided by the standard deviation of the strategy. The Sharpe Ratio measures the excess return for taking on additional risk.

The Sharpe Ratio is one of the most popular performance appraisals measures and is used to compare and rank managers with similar strategies.

Sharpe Ratio Formula

What is a Good Sharpe Ratio?

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

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

As an example, suppose two similar strategies, Strategy A and Strategy B, had the following characteristics over one year. For this period, the average risk-free rate is 0.1%.

Please note: the Sharpe Ratio calculation below has monthly measures as inputs and then annualizes the final result.

Although the strategies perform similarly, the Sharpe Ratios differ significantly due to their differences in volatility (i.e., standard deviation). Because Strategy B has a much higher Sharpe Ratio, it would be preferred over Strategy A to an investor deciding between the two.

Sharpe Ratio Interpretation

The Sharpe Ratio is intended to be used for strategies with normal return distributions; it should not be used for a strategy that treats upside and downside volatility differently. The Sharpe Ratio treats both types of volatility the same. For example, if a manager is looking for high reward investments then upside volatility can be a good thing, but the Sharpe Ratio penalizes the strategy for any type of volatility. For return streams with non-normal distributions, such as hedge funds, the Sortino Ratio may be more appropriate.

Why is the Sharpe Ratio Important?

The Sharpe 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 Sharpe Ratio is commonly used in investment strategy marketing materials because it is the most widely known and understood measure of risk-adjusted performance.

Sharpe Ratio Calculation: Using Arithmetic Mean or Geometric Mean

Because the Sharpe Ratio compares return to risk (through Standard Deviation), 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 Sharpe 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 when calculating performance appraisal measures, please check out Arithmetic vs Geometric Mean: Which to use in Performance Appraisal.

Annualized Sharpe Ratio

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

Investment Performance Outlier Testing

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 complaint, 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 can be 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 uncovered. 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, setting a threshold to look at all portfolios that deviate from the composite return by 50bps will be very different for a composite with low dispersion and a total return of 2% compared to 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 should be considered 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 as being +/-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 should be very clear and easy to identify. If each portfolio you manage is customized, more research will be 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, perhaps, 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 never an outlier for the history, 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

Outlier performance is generally caused by the following:

  • 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 should be removed 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 being managed to the wrong strategy. For example, it is possible that the portfolio could be 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 are deviating and determine if they need to 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.

GIPS Compliance Actions for the New Year 2020

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

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

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

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

High-Level GIPS Topics to Consider Annually

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

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

Changes to the GIPS Standards

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

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

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

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

Changes to Your Firm or Strategies

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

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

Meaningful Composite Structure

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

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

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

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

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

Materiality Thresholds Stated in Your Error Correction Policy

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

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

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

GIPS Verifier Selection and Due Diligence

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

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

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

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

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

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

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

Questions?

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

2020 GIPS Standards: Prepare for the Changes

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.

Arithmetic vs Geometric Mean: Which to use in Performance Appraisal

Most performance appraisal measures utilize a mean return in its calculation. This can be in the form a geometric mean or a simple arithmetic average. Because both types of means can be used, it raises the question: Which measure should be applied?

When calculating performance, we are accustomed to calculating returns geometrically (i.e., including compounding). Because of this, many investment managers use the geometric mean in appraisal calculations as it is easy to use the reported time-weighted return, rather than separately determining the arithmetic mean. But using geometric mean is not the most appropriate choice when evaluating risk-adjusted appraisal measures.

When calculating performance appraisal measures that compare return to risk, such as Sharpe ratio, the return used in the numerator of the ratio should be the arithmetic mean of the return stream, not the geometric mean. In many cases, the difference between using the arithmetic mean versus geometric mean will be immaterial; however, the greater the volatility in the return stream, the more material the difference will be. Let’s look at a simple example that demonstrates this effect:

Strategies with significant volatility have lower geometric means than arithmetic means (7.5% vs. 8.4% for Portfolio 2 above). This is because the geometric mean penalizes the return stream for risk-taking. In the case of the Sharpe Ratio, the standard deviation (which also accounts for risk-taking) in the denominator will be higher as a result of this higher volatility (1.5% for Portfolio 1 vs. 14.2% for Portfolio 2). In this case, using the geometric mean therefore results in a penalty for risk in both the numerator and denominator of the ratio.

Because risk is already being accounted for in the denominator, there is no need to include it in the numerator; in fact, including it would be double-counting the risk taken. As a result, for measures like Sharpe Ratio, it is more appropriate to use the arithmetic mean than geometric mean.

Although, in many cases, using the geometric return will not have a material effect on the outcome when comparing risk-scaled performance measures, it is technically more accurate to use the arithmetic mean. Its implications are more relevant when evaluating strategies with higher volatility. 

GIPS 2020: What’s Changing and What You Should Do (Updated July 2019)

It has been a busy couple of weeks for GIPS! On August 31st, the Exposure Draft of the 2020 Global Investment Performance Standards (GIPS®) was released for public comment and last week (September 14th and 15th) 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.

A Personal Note From Our Founder

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 3rd was not an arbitrary date to launch our firm. This date is significant to me because on September 3rd 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 3rd 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 3rd 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 5th and 15th 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.

GillyDoesKiliPicture

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

How to Advertise as a GIPS Compliant Firm

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

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

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

Why do some GIPS Compliant firms avoid mentioning GIPS?

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

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


The Two Options When Mentioning GIPS

Option 1: Include a Compliant Presentation

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

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

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


Option 2: Follow the GIPS Advertising Guidelines

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

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


Want to learn more?

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