Around the Peak.

Our team has assisted hundreds of firms and asset owners with their GIPS compliance. Over the years, there are some questions that we see quite frequently. This article lists each of these GIPS FAQs and provides some clarification to help navigate the GIPS standards.

Question 1: What are the requirements for distributing GIPS Reports?

The GIPS standards require that all qualified prospective clients and prospective investors (as defined in your GIPS Policies and Procedures) receive relevant GIPS Composite Reports or GIPS Pooled Fund Reports (“GIPS Reports”) once they initially meet this definition. If the prospect still meets this definition 12 months after they initially received the GIPS Report, they are required to receive an updated version of that Report at that time.

Prospective clients include individuals and institutions that are considering opening a segregated account that will be managed in line with any composite strategies. Prospective investors include individuals and institutions that are interested in investing in pooled funds. Additionally, if composite strategies or pooled funds are offered through intermediaries, these intermediaries also must be treated as prospects and must receive the GIPS Reports each year. This includes third party advisors, wrap sponsors, and institutional databases that are used to present strategy information. Responses to Requests for Proposal (“RFPs”) must also include a GIPS Report for any strategies or pooled funds discussed in the RFP.

To clarify, regarding pooled funds, providing the GIPS Report is only required if the fund is a “Limited Distribution Pooled Fund”; “Broad Distribution Pooled Funds” (most mutual funds in the US) are exempt from this requirement. For more information on distinguishing between broad and limited distribution pooled funds, please see question 9 below or check out How to Update Your GIPS Reports for the 2020 GIPS Standards.

Please keep in mind that the requirement to distribute GIPS Reports is relevant to any composite or limited distribution pooled fund a prospect may be interested in, even if they are considered “non-marketed” strategies. In other words, you must always distribute a GIPS Report to a prospect for the strategies they are interested in, even if the composite is not marketed, and even if the prospect doesn’t ask about GIPS or request the report.

Also, the 2020 GIPS standards now require proof that this distribution requirement was met. To do so, distribution now needs to be tracked. There is no required format, but most often this is either done in a CRM system or in Excel. The format must be such that it can be provided upon request to verifiers and/or regulators who wish to see evidence of compliance with this requirement. These internal logs should document who received the GIPS Report, when they received the GIPS Report, which GIPS Report they received, and the form of delivery.

Question 2: To comply with the GIPS standards, are we required to market all composite results and how can performance be presented outside of GIPS Reports?

GIPS Reports are the only required marketing document that must be created and maintained for composites and limited distribution pooled funds to comply with the GIPS standards. Outside of the distribution requirements to prospects (see Question 1), you are not required to present the performance of any composite. Most firms just have a few composites they actively market while the other composites exist primarily to meet the requirement of having every discretionary, fee-paying portfolio in at least one composite. What you choose to present outside of your GIPS Reports is outside the scope of GIPS and can include anything meaningful to your organization and strategies as long as it does not violate any local regulatory requirements, does not conflict with the information presented in the GIPS Report, and is not considered false or misleading.

When advertising, mentioning GIPS is optional. If mentioning GIPS, then either a GIPS Report must be included or the GIPS Advertising Guidelines can be followed instead. The GIPS Advertising Guidelines offer an abbreviated way to mention GIPS compliance without including a full GIPS Report. A checklist of the required advertising disclosures can be downloaded here: 2020 GIPS Advertising Disclosure Checklist.

Since the advertising provisions are optional, mentioning GIPS or the claim of compliance is not required in any documents outside of the GIPS Reports if not desired. Anyone claiming compliance with GIPS may maintain their current procedures for internal client reporting and other marketing documents, as long as there is consistency with GIPS in their strategies and how they hold themselves out to the public.

Question 3: What is the scope of a GIPS verification and are we required to be verified?

GIPS verification provides assurance on whether GIPS 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. Compliance with all applicable requirements of the GIPS standards, even those beyond what is specified in the verification procedures, is required to claim compliance. Therefore, verification does not guarantee the accuracy of any specific performance presentation or set of statistics, but rather opines on the existence of a framework put in place to consistently apply the requirements of the GIPS standards.

During a verification, the selected verifier will use the GIPS policies and procedures to test various aspects of the established framework for GIPS compliance. Undergoing a verification is not a requirement to be able to claim compliance with GIPS, but it is a recommendation set forth by CFA Institute.

Question 4: When should composites utilize minimum asset levels and significant cash flow policies?

The GIPS Standards allow for the creation of composite-specific rules, such as minimum asset levels and significant cash flow policies. The purpose of both policies is to help ensure the composite results are a meaningful representation of the portfolio manager’s discretionary management.

Minimum asset levels ensure that small portfolios that may not be diversified the same as larger portfolios are excluded from composites; significant cash flow policies temporarily remove portfolios from composites for periods where the client is making contributions or withdrawals that are large enough to disrupt the management of the portfolio. Both policies require pre-determined thresholds to be documented in the GIPS policies and procedures document.

For example, if $100,000 is the minimum size needed to fully implement the composite’s strategy, a minimum asset level could be set at $100,000, which would then trigger the exclusion of all portfolios with assets less than $100,000. If a significant cash flow policy has a threshold of 20%, this means that any period where a portfolio experiences a contribution or withdrawal of 20% or more of the portfolio’s fair value, the portfolio is temporarily excluded from the composite for that performance period. Detailed rules must be documented to specify exactly how long the portfolio remains excluded and should be based on the typical amount of time needed to bring the portfolio back in line with the composite’s strategy.

Since these policies are composite-specific, each composite can have different thresholds. You may also elect to set up these policies for some, but not all composites. The most important factor in determining if these policies should be implemented for a composite is whether asset amounts are important to implementation of the strategy and if big external cash flows materially disrupt the investment process. If the strategy is very liquid then these policies may not be necessary. Also, if the composite is large in terms of number of portfolios, a little dispersion caused by small portfolios or portfolios experiencing significant cash flows may have only a very minor impact on the composite results. If the impact is small, the burden of administering the policy may not be worth the effort.

Another important consideration is whether adding these policies to a composite could create performance breaks in the future. If a composite is very small in terms of number of portfolios, these policies should not be utilized unless they are essential to create meaningful composite results. If utilizing these policies creates a scenario where all the composite’s portfolios are excluded for the same period, there will be a break in the performance track record that cannot be linked.

Question 5: When are we required to file the GIPS Compliance Notification form?

GIPS compliant firms and asset owners are required to notify CFA Institute of their claim of compliance once they initially become compliant and once a year thereafter (before June 30^th of each calendar year). We recommend setting reminders on your internal compliance calendar to make sure this requirement is not missed. Firms and asset owners are allowed to complete this form each year between January 1^st and June 30^th with information based on December 31^st of the prior year. Once the annual form is filed, save the email confirmation from CFA Institute. Firms and asset owners that are verified are required to provide this confirmation to their verifier to support that this requirement was met.

Question 6: How do we determine the discretionary status of a portfolio for GIPS purposes?

Not all portfolios with discretionary contracts are considered discretionary for GIPS purposes. Portfolios with material, client-mandated restrictions may be deemed non-discretionary if they are not a meaningful representation of the portfolio manager’s discretionary management. Documentation of the definition of discretion must be maintained in your GIPS policies and procedures to ensure clear criteria can be consistently applied when determining the discretionary status of each portfolio.

The most common criteria documented that trigger portfolios to be deemed non-discretionary for GIPS include:

• Investment restrictions that affect over X% of portfolio assets
• Portfolio manager must obtain client approval prior to trade execution
• Tax sensitivity that restricts trading or requires the harvesting of gains/losses
• Client directed use of margin
• Liquidity needs and/or recurring contributions or distributions
• Restrictions on credit ratings or duration

Please note that this is not an all-inclusive list, nor is it a list of required criteria. We recommend documenting examples that are meaningful to your organization and the types of strategies managed.

Utilizing percentage thresholds can help ensure the criteria is applied consistently. For example, if you manage clients with legacy positions (and these positions cannot be segregated from the strategy for performance purposes) you can set a percentage threshold to indicate when the size of the position is large enough to require exclusion from the composite. Specifically, this means that if the threshold is set at 10%, portfolios with restricted positions totaling less than 10% will be included in the composite while portfolios with restricted positions totaling 10% or more will be excluded from the composite. Using a threshold rather than excluding all portfolios with restrictions in any amount helps reduce the number of non-discretionary portfolios and allows as many portfolios to be included in composites as possible. Again, applying a clear threshold helps ensure there is consistency in the determination of discretionary status.

Question 7: Before we change our portfolio accounting system, what GIPS questions should we consider?

Because the cost of portfolio accounting systems can be significant, it is common to re-evaluate options and occasionally switch systems when feasible to do so. When considering a new system, it is critical that you confirm that the new system’s calculation methodology meets the minimum requirements set forth in the GIPS standards. If considering a newer system that is not well known, it is best practice to confirm that the system has current users that are GIPS compliant and that these users have had their GIPS compliance verified by a reputable GIPS verification firm. Confirming this can provide added comfort that the calculation methodology has been tested.

Once you know that the system meets the requirements of the GIPS standards as well as other general accounting and reporting needs, it is important to plan the logistics of the conversion. Part of this includes ensuring that the historical performance track record is maintained and can be adequately supported to meet the books and records requirements of the GIPS standards.

Standards related to books and records require the ability to support everything reported in your GIPS Reports. Portfolio-level holdings, transactions, prices, etc. should be maintained to be able to reproduce or prove out any statistics requested by a verifier or regulator. If historical results are hardcoded in the new system without portfolio-level details, it is important to ensure that transactions, holdings, prices, etc. are still retrievable in the prior system or from the custodian.

If historical transaction details will be added to the new system, it is important to consider if the historical portfolio and composite results will be hardcoded from the old system or recalculated in the new system. This is because the new system may have a different calculation methodology than the old system (e.g., daily valuation instead of only revaluing for large cash flows) and the historical results may change when recalculated in the new system. The GIPS standards do not allow for a retroactive change to calculation methodology so this new method should only be applied prospectively.

Additionally, we strongly recommend having an overlapping period where both systems run concurrently. Especially when historical periods are recalculated in the new system, it often takes time to get this historical data reconciled to match the old system.

The final consideration includes updating GIPS policies and procedures documents to reflect changes. Documentation of the portfolio accounting change should be made with details describing any changes to methodology. The date of the conversion must be clearly documented with a clear description of what the methodology was before that date and what it will be going forward.

Question 8: What is required when a making a benchmark change?

The GIPS Standards allow changes to the benchmarks used in the GIPS Reports if a different benchmark is considered a more meaningful comparison to the strategy. When a benchmark change is made, benchmark(s) can either be changed prospectively or retroactively.

Prospective benchmark changes are typically made when the composite or pooled fund strategy has shifted and a different benchmark will be a more meaningful comparison for the strategy going forward, while the old benchmark is still the best benchmark for the older periods. Retroactive benchmark changes are typically made when a new benchmark is determined to be a more meaningful comparison for the entire history of the strategy.

Both prospective and retroactive benchmark changes require disclosure in the GIPS Report that had the change. Prospective changes must be disclosed for as long as the original benchmark remains part of the presented information, while the disclosure of a retroactive change may be removed after a one-year period. For example disclosure language see: 2020 GIPS Report Disclosure Checklist.

Question 9: How do we determine if our pooled funds are considered limited or broad distribution and what is different about applying the GIPS standards in each case?

New to the 2020 edition of the GIPS Standards is requirements specifically addressing the presentation of performance to prospective investors in pooled funds. Pooled funds now must be classified as either broad or limited distribution. The best approach to determine this classification is to look at the way these funds are discussed with prospective investors.

If the sales communications are done exclusively in a private, one-on-one setting, the fund is likely a limited distribution pooled fund (e.g., a pooled vehicle set up as a limited partnership). If the fund is offered to prospective investors publicly (e.g., a mutual fund), the fund is likely a broad distribution pooled fund. The determination on whether your pooled fund is a broad or limited distribution fund must be done at the total fund, not share class, level.

Anyone claiming GIPS compliance is required to maintain a list of both types of funds and must include descriptions for the limited distribution funds (descriptions are not required for broad distribution pooled funds). GIPS Reports must be provided to all prospective investors of limited distribution pooled funds, but this is not required for prospective investors in broad distribution pooled funds.

The GIPS Report can be specific to the limited distribution pooled fund itself or it can be for the composite in which the pooled fund is included. Whether providing a GIPS Pooled Fund Report or a GIPS Composite Report, the detailed fees of the fund including the fund’s total expense ratio must be included. For more information on this requirement check out How to Update Your GIPS Reports for the 2020 GIPS Standards.

Regardless of the type of pooled fund, if it meets the definition of an existing composite (i.e., a composite created for segregated accounts), the fund must be included in the composite. If no composite exists matching the strategy of the fund, there is no longer a requirement to include the fund in a composite (i.e., beginning in 2020 creating composites for pooled funds is no longer required if the strategy is only offered to prospective pooled fund investors).

Question 10: When do the GIPS standards allow the calculation of money-weighted returns instead of time-weighted returns?

The use of money-weighted returns (“MWR”) in GIPS Reports instead of time-weighted returns (“TWR”) has broadened under the 2020 edition of the GIPS standards. MWRs may be shown in addition to TWRs if desired; however, if replacing TWR with MWR, certain criteria must be met. Specifically, the manager must control the timing and amount of the external cash flows for the strategy and must also meet at least one of the following criteria:

• The investment vehicle must be closed-end
• The investment vehicle must have a fixed-life
• The investment vehicle must have fixed commitments, or
• A significant portion of the assets in the strategy must be illiquid investments

If a strategy meets these requirements, then the option to present only MWR in the GIPS Report is available, but not required (TWR can still be used if preferred). When switching the returns from TWR to MWR (or vice versa) in the GIPS Report, the change must be disclosed. Switching methodologies should be avoided unless absolutely necessary as one method should be selected as the most meaningful representation of the strategy’s performance. Examples of disclosure language are available here: 2020 GIPS Report Disclosure Checklist.

Questions?

If you have questions contact us or email Matt Deatherage at matt@longspeakadvisory.com.

The Information Ratio is an appraisal measure used to evaluate the skill of a portfolio manager. This ratio is calculated by dividing a strategy’s excess return by its tracking error, which allows us to assess the performance of a strategy relative to its benchmark, after adjusting for risk. Rather than using standard deviation (total risk) or beta (systematic risk) to account for risk, the Information Ratio uses tracking error, which is the standard deviation of the differences in return between the strategy and the benchmark. By scaling excess return by risk, we can compare the performance of multiple managers under consideration in a more equitable manner.

When using Information Ratio, it is important that the benchmark matches the manager’s specific style (i.e., they have the same risk profile). If the benchmark used to evaluate Information Ratio is not truly representative of the risk taken by the manager, the results will be less meaningful. That is, if excess return is earned by deviating from the risk profile of the benchmark, the tracking error will be higher, thus lowering the Information Ratio. This form of risk scaling allows us to identify managers that achieve excess returns without materially deviating from the risk profile of the benchmark.

Information Ratio Formula

Annualized Information Ratio

If using annual or annualized input data, then the results are already in annual terms. When calculating the Information Ratio using monthly data, the Information Ratio is annualized by multiplying the entire result by the square root of 12.

What is a Good Information Ratio?

A positive Information Ratio indicates excess return over the benchmark and a negative Information Ratio signifies underperformance. Since tracking error represents the strategy's consistency with the benchmark, the Information Ratio reveals the level of consistency in which the strategy has achieved its excess returns.

Similar to the Sharpe Ratio, the Information Ratio is usually used as a ranking device to compare managers rather than to evaluate a manager independently; however, some do believe that the Information Ratio can provide insight into the skill of a manager on its own. Generally, an information ratio of 0.5 is considered good while a ratio of 0.75 is very good and 1.0 or higher is exceptional. Just like other appraisal measures, the results are more meaningful when assessed over longer periods, ideally 36 months or more, as it is much easier to achieve positive results in the short term.

Information Ratio Calculation Example

Suppose two similar strategies, Strategy A and Strategy B, had the following annualized characteristics.

Although the strategies have the same annualized excess return, the Information Ratios differ due to their differences in tracking error. Because Strategy A has a higher Information Ratio, it would be preferred over Strategy B to an investor deciding between the two.

Again, this calculation implicitly assumes that the benchmarks used correspond to the respective risk profile of each strategy.

Information Ratio Interpretation

Often, annualized Information Ratios are used to rank managers. This direct comparison works well when comparing managers with the same length of performance history; however, it is important to also consider if any adjustments are needed to compare managers with different lengths of performance history. For example, a manager’s annualized Information Ratio calculated using 10 years of history compared to a different manager’s Information Ratio calculated using 3 years of history may not be perfectly comparable for two reasons: 1) the excess returns may have at least partially been earned under different market conditions and 2) a shorter track record provides us with less statistical confidence in the results.

Regarding statistical significance, it is important to remember that all performance appraisal measures are estimated with error. Using t-statistics to measure statistical significance of the results (i.e., adjusting to assign more confidence to a longer track record) may add value to simply comparing pure Information Ratios. That is, without considering statistical confidence levels, we may select a manager with a higher Information Ratio despite their being less certainty in the meaningfulness of their results compared to a manager with a longer track record and slightly lower Information Ratio.

Additionally, it is important to consider multiple appraisal measures when evaluating a manager to ensure you have the full picture of the manager’s skill. If you want to compare Information Ratio to other ratios like Sharpe Ratio or Sortino Ratio, take a look at What is the Sharpe Ratio or What is the Sortino Ratio?

Why is the Information Ratio Important?

When managers are compared that have similar styles and active risk budgets, the Information Ratio is a valuable tool to identify skill and rank managers. Managers in a peer group may indicate that they have a similar risk profile and track the same benchmark. Using tracking error to risk-adjust the excess return of each manager can test whether the managers truly have similar risk profiles. The Information Ratio helps us identify which managers consistently earned their excess return without material deviations from the risk profile of the benchmark or other managers in their peer group.

Information Ratio Calculation: Using Arithmetic Mean or Geometric Mean

Because the Information Ratio compares return to risk (through tracking error), Arithmetic Mean should be used to calculate the strategy return. Geometric Mean penalizes the return stream for taking on more risk. However, since the Information 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.

Contact Us

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

The week of October 26th, CFA Institute hosted the 24^th annual GIPS Conference. It was the first of its kind, with speakers presenting virtually from the comfort of their own homes and offices.

Most of this year’s conference was focused on compliance with the 2020 GIPS standards, as well as important discussions around US-specific (SEC) regulatory compliance and ESG performance. Below are some key takeaways from this three-day event.

Specific Takeaways Relating to GIPS Compliance

The 2020 GIPS standards were released at the end of June 2019, so the industry has had some time to absorb the updates that were made. All changes firms are required to make must be completed before presenting performance for periods including 31 December 2020 in the firm’s GIPS Reports.

With the end of 2020 fast approaching, the conversion to the 2020 standards was the focus of this year’s conference. We have previously published information relating to converting your GIPS Reports and Policies and Procedures for GIPS 2020 so we will not repeat that all here, but below are some of the key points that were emphasized during the conference:

Broad vs. Limited Distribution Pooled Funds

The treatment of pooled funds is one of the most significant changes made to the GIPS standards for 2020. Since the requirements for how pooled funds are treated differ depending on whether they are classified as Broad Distribution Pooled Funds (“BDPF”) or Limited Distribution Pooled Funds (“LDPF”), the speakers emphasized how to distinguish between the two.

Pooled funds are different than segregated accounts in that their ownership interests may be held by more than one investor. A BDPF is regulated in a way that permits the general public to purchase or hold the fund’s shares, and this type of pooled fund is not exclusively offered in one-on-one presentations. On the other hand, a LDPF is any pooled fund that does not fit into the category of a BDPF.

The classification between the two types of pooled funds is made at the fund level rather than the share class level. Some common examples of BDPFs include pooled funds with at least one retail share class and pooled funds with shares traded on an exchange. The most common BDPFs in the U.S. are mutual funds. LDPFs include any pooled fund that a firm offers exclusively in one-on-one presentations.

The distinction between the types of pooled funds is important because there are different requirements that need to be met depending on whether the fund is a BDPF or LDPF. Specifically, firms are not required to provide a GIPS Report to BDPF prospective investors, but they must make every reasonable effort to provide a GIPS Report to all LDPF prospective investors when they initially become a prospect and every twelve months thereafter for as long as they remain a prospective investor.

The GIPS Report provided to LDPF prospective investors can be either a GIPS Pooled Fund Report or a GIPS Composite Report for the composite in which the LDPF is included. Regardless of which is provided, the report must disclose the fees specific to the fund including the fund’s total expense ratio. Firms choosing not to create a separate GIPS Pooled Fund Report may wish to maintain multiple versions of their GIPS Composite Report so a version with pooled fund fees can be provided to prospective pooled fund investors and a version with just management fees can be provided to prospective segregated account clients.

Firms Must Gain an Understanding of their Verifier’s Policies for Maintaining Independence

Independence is an important topic relating to GIPS verification. Ensuring that verifiers do not step into a management role, set policies, calculate returns, etc. is essential for the verification to be meaningful. Only when the verifier remains independent will the verification letter truly represent the opinion of an unbiased third-party.

Firms are not required to be verified but investing in verification brings additional credibility to a firm's claim of compliance. At the GIPS Conference, the speakers emphasized that under the 2020 GIPS standards, if a firm chooses to be verified it must:

1. Gain an understanding of the verifier’s policies for maintaining independence.
2. Consider the verifier’s assessment of independence.

This is an ongoing process, and these steps must be performed with each verification engagement. To properly adhere to these requirements, firms should obtain a summary of the verifier’s policies for ensuring independence and have sufficient discussions with the verifier to understand the policies and identify any conflicts of interest.

When issues come up that require the help of GIPS expert, utilizing the help of an independent GIPS consultant, such as Longs Peak, rather than the firm’s verifier helps ensure the verifier’s independence is not jeopardized.

Requirement to Maintain a GIPS Report Distribution Log

Firms have always been required to make every reasonable effort to distribute GIPS Reports to prospects; however, under the 2020 GIPS standards, firms are now also required to demonstrate their effort to do so.

The speakers at the conference emphasized that not only is it now required to demonstrate this effort, but verifiers will be testing this. This means that firms should track the distribution in a manner that can be easily converted into a report to provide to their verifier. There is no specific requirement as to how this is tracked, but the most common is to log the relevant information into a CRM database or in a spreadsheet if a CRM is not used.

Next Steps for CFA Institute

CFA Institute is constantly updating their resources related to the GIPS standards and will continue to do so. During the conference, a list of “next steps” was discussed.

1. The Q&A Database will be updated to ensure the current Q&As are relevant to the 2020 standards. Q&As that are no longer relevant will be archived.
2. Existing Guidance Statements will be updated to ensure they adhere to the 2020 standards.
3. CFA Institute is in the process of finalizing exposure draft Guidance Statements related to benchmarks, overlay strategies, risk, and supplemental information.
4. The creation of tools and resources to assist with implementation of the 2020 edition of the GIPS standards will continue. Updates on new tools/resources will be posted on the CFA Institute website as well as announced in monthly emails. To subscribe to the GIPS standards newsletter please follow instructions here.

Regulatory (SEC) Compliance Takeaways

The SEC's Proposed New Advertising Rule

The main focus of the SEC compliance portion of the conference was to discuss the proposed new Advertising Rule. The new Advertising Rule should be finalized in the next couple months, and firms will have one year to comply once it is finalized.

Historically, firms have relied on “No-Action Letters” and other interpretive guidance to ensure advertisements do not violate SEC requirements. The new Advertising Rule is expected to consolidate this miscellaneous guidance into a set of principles-based provisions with an overarching emphasis on ensuring advertisements are fair and balanced.

Some of the key elements of the proposed new Advertising Rule are below.

• As proposed, the definition of “advertisement” will be broadened to include “any communication, disseminated by any means, by or on behalf of an investment adviser, that offers or promotes the investment adviser’s investment advisory services or that seeks to obtain or retain one or more investment advisory clients or investors in any pooled fund vehicle advised by the investment adviser.” While there will be certain exclusions, this essentially broadens the definition to include all promotional emails, text messages, and any pre-recorded podcasts. It also makes the firm responsible for ensuring that any third-party content promoting advisory services on behalf of the firm also adheres to the Advertising Rule.

• The proposed rule prohibits advertisements from including performance results from fewer than all portfolios with substantially similar investment policies, procedures, objectives, and strategies, with limited exceptions. This better aligns the SEC rules with the GIPS standards, as it moves firms towards composite construction rather than using representative accounts. There do appear to be exceptions to the rule where representative accounts could be used as long as the return of the representative account is no higher than the average return of all portfolios managed with the same strategy; however, this could be difficult to support without calculating the composite returns. We expect that composite returns will become the norm, even for firms not complying with the GIPS standards.

• The new rule also emphasizes the requirement of pre-use review and approval of all advertisements prior to dissemination. This review and approval can be designated to one or more employees with the competence and knowledge regarding the requirements, and the designated employee(s) should generally include legal or compliance personnel. Exclusions from this rule would include live oral communications that are not widely broadcast and communications disseminated only to a single person or household or to a single investor in a pooled fund vehicle.

Once this new Advertising Rule is finalized, advisers can use the one-year transition period to develop and adopt appropriate policies and procedures to comply with the new rule. Since the new rule is not yet finalized, no immediate action is required at this time other than starting to consider what changes will likely be necessary for your firm.

ESG Takeaways

As ESG-based investing has become increasingly popular, the GIPS Conference included a session discussing ESG performance attribution. Environmental, Social, and Governance (“ESG”) refers to three of the main factors in measuring the sustainability and societal impact of an investment. Measuring ESG essentially refers to measuring how much of an investment’s performance can be attributed to ESG considerations in the investment process.

Sources of ESG Data

ESG data has evolved over time, and there are multiple categories of sources. The main sources used historically are Corporate Governance Disclosures as well as news and media sources. A very systematic quality control process of evaluating ESG data needs to be in place to properly interpret the data.

Some of the sources that are becoming increasingly available are alternative data sources, such as government regulatory agency databases and models for ESG metrics. Data from alternative sources requires expertise to extract and properly shape in order for the data to be useful.

Materiality of ESG Data

ESG data is generally not very uniform or standardized, and there are biases that exist across the various sources. Discussions during the ESG portion of the conference compared the current state of ESG data to financial data of the past. There was a period of time when financial data was in this “messy” state before reporting standards were put in place and the process of unifying global financial data was undertaken. ESG data is expected to follow a similar path.

Zeroing in on what is material and what factors matter while evaluating a company is an important part of the investment process. There are many factors to consider while assessing ESG inputs, but determining the key factors relevant to any given business model is essential.

Conclusion

Overall, the GIPS Conference was a success despite not being able to meet in person. The networking is always a fun and important aspect of the conference, but the virtual conference still was able to provide useful practical tips for implementing the 2020 GIPS standards as well as other related performance topics.

If you have any questions about the GIPS Conference or GIPS and performance in general, please feel free to contact us.

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

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

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

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

Deadline to Update GIPS Reports

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

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

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

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

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

For firms that are verified

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

A firm that claims compliance with the GIPS standards must establish policies and procedures for complying with all the applicable requirements of the GIPS standards. Verification provides assurance on whether the firm’s policies and procedures related to composite and pooled fund maintenance, as well as the calculation, presentation, and distribution of performance, have been designed in compliance with the GIPS standards and have been implemented on a firm-wide basis. Verification does not provide assurance on the accuracy of any specific performance report.”

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

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

A firm that claims compliance with the GIPS standards must establish policies and procedures for complying with all the applicable requirements of the GIPS standards. Verification provides assurance on whether the firm’s policies and procedures related to composite and pooled fund maintenance, as well as the calculation, presentation, and distribution of performance, have been designed in compliance with the GIPS standards and have been implemented on a firm-wide basis. The [insert name of COMPOSITE] has had a performance examination for the periods [insert dates]. The verification and performance examination reports are available upon request.”

For firms that have not been verified:

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

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

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

3.  Add the composite’s inception date.

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

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

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

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

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

2020 GIPS Report Changes for Firms with Pooled Funds

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

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

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

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

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

2020 GIPS Report Utilizing Money-Weighted Returns

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

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

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

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

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

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

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

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

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

2020 GIPS Report Changes for Asset Owners

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

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

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

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

2020 GIPS Report Changes for other Optional Policies

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

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

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

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

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

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

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

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

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

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

Questions?

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

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

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

Sortino Ratio Formula

Annualized Sortino Ratio

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

What is a Good Sortino Ratio?

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

Sortino Ratio vs. Sharpe Ratio Calculation Example

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

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

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

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

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

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

Sortino Ratio Interpretation

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

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

Why is the Sortino Ratio Important?

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

Sortino Ratio Calculation: Using Arithmetic Mean or Geometric Mean

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

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

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

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

GIPS 2020: Minimum Requirements for all GIPSCompliant Organizations

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

Terminology

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

Demonstrate that GIPS Reports are Distributed

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

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

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

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

Error Correction Procedures

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

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

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

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

Verifier Independence

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

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

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

GIPS Report Updates

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

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

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

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

GIPS 2020: Changes for Firms with Pooled Funds

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

Terminology

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

List of Pooled Funds

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

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

Pooled Fund Inception Date

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

Error Correction Thresholds

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

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

Changes for other Optional Policies

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

Carve-Outs

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

Portability

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

Estimated Transaction Costs

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

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

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

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

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

Model Management Fees

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

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

Presenting Advisory-Only Assets

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

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

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

Presenting Money-Weighted Returns

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

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

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

Other Considerations for GIPS Policies &Procedures

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

Questions?

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

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

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

What is Changing and Why

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

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

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

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

How the 2020 GIPS Standards are Organized

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

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

Where to Start – GIPS Compliance Updates

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

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

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

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

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

GIPS 2020 Checklist 

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

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

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

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

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

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

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

Investment Performance in Up-Markets vs Down-Markets

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

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

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

Types of Investment Risk

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

Systematic Risk Statistics

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

If every time the benchmark goes up 1% the strategy goes up 1.2% and every time the benchmark goes down 1% the strategy goes down 1.2% then the beta is 1.2. This means that the portfolio has increased its systematic risk (perhaps through adding leverage, but otherwise replicated the index). In this case, the portfolio manager has increased the strategy’s systematic risk and volatility as compared to the benchmark, but the manager has not added alpha. This strategy will outperform on the upside and underperform on the downside.

To determine if the portfolio manager has “added alpha,” you can calculate Jensen’s alpha for the strategy. Jensen’s alpha measures how much the strategy outperformed its expected return, with the expected return determined based on the risk-free rate plus the beta-adjusted benchmark return. If the portfolio manager is truly “adding alpha” (through stock selection, over/underweighting sectors, etc.) and not just increasing systematic risk in their active management, then the strategy’s Jensen’s alpha should be positive.

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

Total Risk Statistics

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

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

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

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

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

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

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

Tools to Calculate Risk Statistics

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

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

Questions? 

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

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

Why Utilize Composites?

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

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

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

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

Why test for performance outliers?

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

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

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

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

How can performance outliers be identified?

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

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

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

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

What to consider when reviewing outlier performance

The severity of the outlier

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

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

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

How often the portfolio is an outlier

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

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

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

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

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

Common causes of outlier performance:

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

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

Ready to implement performance outlier testing at your firm?

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

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

Questions? 

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