Around the Peak.

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

Treynor Ratio Formula

Annualized Treynor Ratio

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

What is a Good Treynor Ratio?

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

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

Example Treynor Ratio Calculation

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

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

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

How to Interpret Treynor Ratio

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

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

Why is Treynor Ratio Important?

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

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

Treynor Ratio Calculation: Using Arithmetic Mean or Geometric Mean

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

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

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

How the Testing Sample is Determined

The end goal of verification is the opinion letter that attests to “whether the firm's policies and procedures related to composite and pooled fund maintenance, as well as the calculation, presentation, and distribution of performance, have been designed in compliance with the GIPS standards and have been implemented on a firm-wide basis.”

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

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

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

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

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

What to expect with the Verification Testing Request

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

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

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

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

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

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

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

Membership Testing

Entry Testing

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

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

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

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

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

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

Exit Testing

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

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

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

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

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

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

Outlier Testing

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

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

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

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

Non-Discretionary Testing

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

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

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

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

Portfolio-Level Return Testing

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

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

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

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

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

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

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

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

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

Wrapping up the Verification

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

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

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

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

Conclusion

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

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

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.

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

Sharpe Ratio Formula

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.

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.

Example Sharpe Ratio Calculation

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

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

Although the strategies have the same average monthly return over the one-year period, 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 is 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.

Recently we have observed numerous trends in the investment industry for a higher level of transparency and more standardized reporting from investment managers. To name a few, the SEC is pushing for more comprehensive advertising requirements with the Modernized Marketing Rule for Investment Advisors and FINRA with rule 2210 for Communications with the Public for Fund Managers. The most recent proposed update for standardized performance reporting has come from the SEC in a series of amendments aiming to enhance private fund reporting.

Liquid Fund Performance:

A liquid fund, defined as “any private fund that seeks to generate income by investing in a portfolio of short-term obligations in order to maintain a stable net asset value per unit or minimize principal volatility for investors,” is required to present annual total investment returns on a net basis since the inception of the fund. In addition to the annual net return requirements, the proposal also requires the presentation of annualized net returns covering a one-, five-, and ten-year period (as well as since-inception if the fund has not been in existence for any of the stated time periods required). An additional metric the proposal is pushing for is the cumulative return through the most recent period end (defined as the most recent quarter-end), net-of-fees.

Illiquid Fund Performance:

An illiquid fund, which is defined as “any fund investing in securities that cannot be sold or disposed of in the ordinary course of business within seven calendar days at approximately the value ascribed to it by the fund,” is required to present a series of money-weighted return statistics (e.g., Internal Rate of Return (“IRR”)). These statistics include the gross and net since-inception money-weighted return and the gross invested capital multiple (also known as the “MOIC”) as of the most recent calendar quarter-end, without the impact of any subscription lines of credit used.

Disclosures:

Both liquid and illiquid funds will be expected to include robust disclosures regarding the adopted calculation methodology and any assumptions made in the calculation of presented statistics. In addition to the criteria being used, illiquid funds will be expected to include prominent disclosures regarding the contributions and withdrawals to and from fund investors, as well as the fund’s current net asset value. Outside of calculation methodologies, the SEC is proposing detailed disclosures to be required outlining any and all applicable fees and expenses that have been, and are expected to be, incurred in the management of the fund. These proposed disclosures would be in addition to existing required SEC disclosures.

Comment Period:

These proposed rules are not yet finalized. The public comment period will remain open for 60 days proceeding the release on these proposed rules amendments (which was released in February 2022). Once the comment period concludes, the SEC will consider feedback provided and finalize the new amendments. For more information on this recent press release, and the proposed amendments to the rule, see the full press release here.

Contact Us

Longs Peak is a consulting firm specialized in helping investment firms and asset owners calculate and present investment performance. If you need assistance preparing for any of these new proposed rules, please contact us at hello@longspeakadvisory.com or visit our website at https://longspeakadvisory.com/.

LONGMONT, Colorado, January 12, 2022 – Longs Peak Advisory Services, LLC (“Longs Peak”) announced today that the company has appointed Matthew Deatherage, CFA, CIPM as equity Partner, effective January 1, 2022.

Mr. Deatherage has over 8 years of experience specifically in GIPS and Investment performance and has worked with some of the world’s largest financial institutions to help them with their GIPS compliance. Before being promoted, Matt served as a Senior Manager and member of Longs Peak’s Executive Team. In this role, he was responsible for developing the company’s Client Experience, Training & Development, and Quality Control processes. In addition, Matt spearheads Longs Peak’s Alternative Asset Management GIPS projects. Since joining, Matt has helped the company nearly double the number of clients we serve. Prior to working at Longs Peak, Matt worked for ACA Compliance Group and Ashland Partners.

“I am honored to be made Partner," said Matt. "In my experience with the company, I’ve developed a deep appreciation for what makes Longs Peak so special. Longs Peak’s success is rooted in the team we have built and the customers we serve. I believe we have so much opportunity to capitalize on this foundation, innovate for the future and continue to grow. I look forward to continuing to work with our global client base and growing team to deliver on our goal to simplify how investment firms calculate and present investment performance."

“We have all been impressed by Matt’s leadership and track record of operating with excellence, executing on client engagements and cultivating a team that drives results. Matt has consistently delivered on building our client relationships and our team’s expertise,” said Jocelyn Gilligan, CFA, CIPM, Partner. “Longs Peak wouldn’t be the same without him.”

“Since meeting Matt almost a decade ago when we both worked for a large GIPS verification firm, I knew he had a lot of potential,” said Sean Gilligan, CFA, CPA, CIPM, Managing Partner. “His experience and ambition add a ton of value to our clients and our firm. The entire Longs Peak team is excited about his promotion as we all benefit so much from his leadership and technical expertise. We know he has the drive to help bring Longs Peak and our clients into a new chapter of growth and success.”

About Longs Peak

Longs Peak Advisory Services, LLC is a consulting firm specialized in helping investment firms and asset owners calculate and present investment performance. Longs Peak has worked with over 170 firms across North America, Europe, and Asia since its inception in 2015 to help them calculate and present investment performance or comply with the GIPS Standards.

Contact

Longs Peak

hello@longspeakadvisory.com

Matt Deatherage, CFA, CIPM

matt@longspeakadvisory.com

Related Links:

https://longspeakadvisory.com/

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.

What do Capture Ratios Explain?

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

What is the Up-Market Capture Ratio?

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

Up-Market Capture Formula

How to interpret the Up-Market Capture Ratio

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

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

What is the Down-Market Capture Ratio?

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

Down-Market Capture Formula

How to interpret the Down-Market Capture Ratio

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

What is Total Capture Ratio?

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

Total Capture Ratio Formula

How to interpret Total Capture Ratio

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

Why are Capture Ratios Important?

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

Questions?

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

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

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

Updated Resources for the 2020 GIPS Standards

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

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

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

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

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

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

There were several new Q&As issued addressing 2020 standards topics. The Q&A Database can be accessed here.

FINRA Regulatory Notice 20-21

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

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

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

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

For firms that do NOT claim compliance with the GIPS standards:

[Insert firm name] has calculated the since-inception internal rate of return (SI-IRR) and fund metrics using a methodology that is consistent with the calculation requirements of the Global Investment Performance Standards (GIPS®). [Insert firm name] does not claim compliance with the GIPS standards. GIPS® is a registered trademark of CFA Institute. CFA Institute does not endorse or promote [insert firm name], nor does it warrant the accuracy or quality of the content contained herein.

For firms that claim compliance with the GIPS standards:

[Insert firm name] has calculated the since-inception internal rate of return (SI-IRR) and fund metrics using a methodology that is consistent with the calculation requirements of the Global Investment Performance Standards (GIPS®). [Insert firm name] claims compliance with the GIPS standards. GIPS® is a registered trademark of CFA Institute. CFA Institute does not endorse or promote [insert firm name], nor does it warrant the accuracy or quality of the content contained herein.

Databases & the GIPS Standards

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

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

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

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

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

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

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

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

ESG Disclosures

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

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

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

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

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

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

SEC Marketing Rule

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

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

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

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

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

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

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

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

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

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

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

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

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

Conclusion

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

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

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

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

What is Financial Batting Average?

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

Financial Batting Average Formula

How to interpret Batting Average

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

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

Why is Batting Average Important?

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

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

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

Contact Us

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