Around the Peak.

Recent investment performance calculation mistakes at Pennsylvania Public School Employees’ Retirement System (“PSERS”) have highlighted the importance of quality control reviews and raises questions about where risk exists, how these risks can be mitigated, and what role independent verifications should play in the quality control process.

What happened at PSERS?¹

An error in the return calculation for Pennsylvania’s $64 billion state public school employee retirement plan has had serious implications for its beneficiaries and those involved in the calculation mistake.

In 2010, the plan, which was already underfunded, entered into a risk-sharing agreement where employees hired after 2011 would pay more into the plan if the return (average time-weighted return) over a specific time period fell below the actuarial value of asset (AVA) return of 6.36%.

In December 2020, the board announced that the plan had achieved a return of 6.38%, a mere 2 basis points above the minimum threshold. But in March the board changed its tune, announcing that the calculation was incorrect and the 100,000 or so employees hired since 2011 (and their employers) should have actually paid more into the plan.

What’s worse is PSERS also announced that the FBI is investigating the organization, although details of the probe have not yet been released.

According to PSERS, a consultant, that had calculated the return, came forward and admitted to the calculation error. But the board also said that it is looking into potential cover up by its staff. From what we know, at least 3 independent consultants were involved in providing data used for the calculations, calculating the returns, and verifying the returns. So, with all these experts involved, how could this happen and what can your firm do to avoid a similar situation?

Key issues to address in an investment performance quality control process

Firms should develop sound quality control processes to help identify errors before results are published. Often these processes either do not exist or are insufficient to identify issues. Following a robust quality control process that considers the key risks involved and then finds ways to mitigate these risks greatly increases the accuracy of presented investment performance.

Although we do not yet know the cause of the errors found in the PSERS case, we can highlight a few primary reasons errors occur in investment performance reporting. Primarily, errors found in published performance results are caused by:

• Key Issue # 1 – Issues in the underlying data (e.g., incorrect or missing prices, unreconciled data, missing transactions, misclassified expenses, or failing to accrue fixed income)
• Key Issue #2 – Mistakes in calculations (e.g., manual calculations that fail to match the intended methodology)
• Key Issue #3 – Errors in reporting (e.g., publishing numbers that do not match the calculated results)

A robust quality control process should specifically address all three of these areas.

Considerations when designing a robust quality control process

Key Issue #1 – Issues in the underlying data

As they say, garbage in, garbage out. It is important to ask and address questions confirming the validity of data before it is used to calculate performance. Specifically, consider how the data used in the calculations is gathered, prepared, and reconciled before completing the calculations. Is there any formal signoff from the operations team confirming that the data is ready for use? Has a review of the data been conducted by an operations manager prior to this confirmation being made?

While deadlines to get performance published can be tight, taking the time to ensure that the underlying data is final and ready to use before performance is calculated can prevent headaches later on.

The following is a list of issues to look for when testing data validity:

• Outlier performance – Portfolios performing differently than their peers may indicate a data issue or that the portfolio is mislabeled (i.e., tagged to a different strategy than it is invested in).
• Differences between ending and beginning market values – Generally, we expect a portfolio’s market value at the end of one month and the beginning of the next month to be equal (unless using a system where external cashflows are recorded between months and differences like this are expected). Flagging differences can help identify data issues.
• Offsetting decrease/increase in market value – Market values that suddenly increase or decrease and then return to the original value may have an incorrect price or transaction that should be researched.
• Gaps in performance – A portfolio whose performance suddenly stops and then restarts may have missing data.
• 0% returns – The portfolio may have liquidated and may no longer be under the firm’s discretionary management.
• Very low market values – The portfolio may have closed and is only holding a small residual balance, which should be excluded from the firm’s discretionary management.
• Net-of-fee returns higher than gross-of-fee returns – Seeing net returns that are higher than gross returns could indicate a data issue unless there are fee reversals you are aware of (e.g., performance fee accruals where previously accrued fees are adjusted back down).
• Gross-of-fee returns and net of-fee returns are equal – If gross-of-fee and net-of-fee returns are always equal for a fee-paying portfolio, it is likely that the management fees are paid from an outside source (paid by check or out of a different portfolio). The returns labelled as net-of-fee in a case like this should be treated as gross-of-fee returns.

Key Issue #2 – Mistakes in calculations

Mistakes happen, but there are ways to reduce their frequency and impact. First, you’ll want to consider how manual your performance calculations are as well as the experience of the person completing the calculations.

Let’s face it, Excel is probably the most widely used tool in performance measurement, especially for smaller firms. While many firms likely find Excel to be a user-friendly tool for calculating performance statistics, it has its limitations. Studies have shown that up to 90% of spreadsheets contain errors and spreadsheets with lots of formulas are even more likely to contain mistakes. Whether it’s not properly dragging down a formula or referencing the wrong cell, fundamentally, the biggest problem is that users do not check their work or have carefully outlined procedures for confirming accuracy.

Although this may seem obvious, having a second set of eyes on a spreadsheet can save you from the embarrassing headache of having to explain errors in performance calculations. It is even better if this review is a multi-layered process. Having someone review details as well as someone to do a high-level “gut-check” to make sure the calculations and results make sense can reduce this risk. Depending on the size of your firm, this may be easier to accomplish with a third-party consultant, where you serve as a final layer of review.

Having this final “gut-check” can help prevent avoidable errors prior to publication. We find that this final “gut-check” is best performed by someone who knows the strategy intimately rather than a performance or compliance analyst, as these individuals may be too focused on the calculation details to take a step back and consider whether the returns make sense for the strategy and are in line with expectations.

If you use software to calculate performance, you can significantly reduce the risk of manual error, but due diligence should still be performed from time to time to manually prove out the accuracy of the calculations completed in the program. This does not need to be done every time but should be conducted when introducing a new software system and any time changes are made to the program.

Key Issue #3 – Errors in reporting

It may seem silly, but many performance reporting errors come from transposing strategy and benchmark returns in presentations or placing the return of one strategy in the factsheet of another. Therefore, it is important to consider how the final performance figures make it from the system or spreadsheet into the performance presentations. Are they typed? Copy and pasted? Or are the performance reports generated directly out of a system? It’s not enough to complete the calculations correctly, the final reports must also be accurate, so adding a step to review this is crucial.

A similar review process to the one described above can really make a difference, but ultimately, understanding the vulnerabilities of your performance reporting will help you design quality control procedures that address any exposure.

Calculations completed by external performance consultants

Whether performance is calculated internally or by a third-party performance consultant, the same key issues should be considered when designing the quality control process. Due diligence should be done on the performance consulting firm to evaluate the level of experience the firm has with calculating investment performance and what kind of quality control process they follow prior to providing results to your firm. This information will help you determine what reliance you can place on their procedures and what your firm should still check internally.

For example, outsourcing performance calculations to an individual or single-person firm likely necessitates a more in-depth review since this individual would not have the ability to have a second set of eyes on the results prior to providing them to your firm. However, even larger performance consulting firms with robust quality control processes may not have intimate knowledge of your strategies, meaning that, at a minimum, a final “gut-check” should be done by your firm prior to publication.

Reliance on independent performance verification firms to find errors

Many firms that hire performance verification firms rely on their verifier to be their quality control check; however, this may not be a good practice for a variety of reasons. If this is a common practice at your firm, you may want to check the scope of your engagement before relying too heavily on your verifier to find errors.

Verification is common for firms that claim compliance with the Global Investment Performance Standards (GIPS®). But even firms that claim compliance with the GIPS standards and receive a firm-wide verification are required to disclose that, “…Verification does not provide assurance on the accuracy of any specific performance report.”

This is because verifiers are primarily focused on the existence and implementation of policies and procedures. While their review may help identify errors that exist in the sample selected for testing, it specifically does not certify the accuracy of presented results. While the verification process is valuable and often does turn up errors that need to be corrected, regardless of the scope of your engagement, a robust internal quality control process is likely still warranted.

Firms that are not GIPS compliant may engage verification firms for various types of attestation or review engagements like strategy exams or other non-GIPS performance reviews. In these situations, the scope of the engagement may be customized to meet the needs (and budget) of the firm seeking verification. A clear understanding of exactly what is in-scope and specifically what the verifier is opining on when issuing their report is key.

Situations where the engagement entails a detailed attestation tracing input data back to independent sources, confirming that calculations are carried out consistently, and verifying that published results match the calculations, allow for heavy reliance on the verifier as part of your quality control process.

Alternatively, when the scope merely consists of a high-level review confirming the appropriateness of the calculation methodology, a much more robust internal quality control process should be applied.

Knowing the scope of the engagement your firm has established with the verification firm is an important element in determining how much reliance can put on their review and findings, which can then be incorporated into the design of your own internal quality control procedures.

Key take-aways

Mistakes happen in investment performance reporting, but a robust quality control process can greatly mitigate this risk. Understanding the risks that exist, designing processes to test these risk areas, and understanding the role and engagement scope of all consultants involved are essential items in designing a quality control procedure that work for your firm – and hopefully one that will help you avoid situations like what happened with PSERS.

If you are not sure where to begin, we have tools and services available to help. Longs Peak uses proprietary software to calculate and analyze performance. Our software helps flag possible data issues and outlier performers and also produces performance reports directly from our performance system.

In addition, our performance consultants are available to work with your team to help identify potential vulnerabilities in your performance reporting process and can help you develop better quality control procedures, where needed.

Questions?

If you would like to learn more about our quality control process or any of the services we offer (like data and outlier testing) to help improve the accuracy and reliability of investment performance, contact us or email Sean Gilligan directly at sean@longspeakadvisory.com.

¹ For more information on PSERS, please see this article from the Philadelphia Inquirer.

In July 2020, the Financial Industry Regulation Authority (FINRA), a government-authorized not-for-profit organization that oversees US broker-dealers, published Regulatory Notice 20-21, which addresses retail communications concerning private placement offerings. Specifically, Regulatory Notice 20-21, which addresses FINRA Rule 2210 and the use of IRR in retail communications for completed investment programs, now requires IRR to be calculated according to the methodology outlined in the GIPS® Standards.

What is GIPS?

The Global Investment Performance Standards (GIPS®) are a set of voluntary standards utilized by investment managers and asset owners throughout the world to provide full disclosure and fair representation of their investment performance.

The fundamental aim of GIPS compliance is transparency and consistency. Firms that comply with the GIPS standards improve transparency in the industry and standardize reporting, allowing prospects evaluating managers with similar strategies to make the comparison easier and more meaningful.

What does FINRA Rule 2210 have to do with the GIPS standards?

Within the Regulatory Notice, FINRA states that, “FINRA interprets Rule 2210 to permit the inclusion of IRR if it is calculated in a manner consistent with the Global Investment Performance Standards (GIPS) adopted by the CFA Institute and includes additional GIPS-required metrics such as paid-in capital, committed capital and distributions paid to investors.” Ultimately, this means that firms that present IRRs in private placements must now calculate and present performance information in accordance with the methodology outlined in the GIPS standards.

This understandably has led to some confusion for non-GIPS compliant firms that include IRR performance in private placement offerings.

In the CFA Institute’s March 2021 GIPS Standards Newsletter, some common questions were addressed regarding FINRA Regulatory Notice 20-21 and its reference to the GIPS standards. Please keep in mind that CFA Institute’s interpretation of the Regulatory Notice has not been adopted or endorsed by FINRA. The key takeaways from the questions and answers listed in the newsletter are listed below.

Key Takeaways From CFA Institute about FINRA Regulatory Notice 20-21:

A firm is not required to claim compliance with the GIPS Standards in order to comply with FINRA Regulatory Notice 20-21.

An exception is being made to allow firms and their agents to make a specific statement regarding the GIPS Standards only in retail communications concerning private placements offerings that are prepared in accordance with FINRA Regulatory Notice 20-21.

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

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

For firms that claim compliance with the GIPS standards:

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

Any IRR, as well as the additional metrics required under the GIPS standards, must meet the input data and calculation requirements of the GIPS standards.

Additional metrics must be included when presenting IRR performance in compliance with the GIPS standards. The following metrics are required under the GIPS Standards:

• Since-inception paid-in capital (PIC) – The amount of committed capital that has been drawn down
• Since-inception distributions
• Cumulative committed capital – The capital pledged to the investment vehicle
• Total value to since-inception paid-in capital (TVPI or investment multiple) - TVPI provides information about the value of the composite relative to its cost basis
• Since-inception distributions to since-inception paid-in capital (DPI or realization multiple)
• Since-inception paid-in capital to cumulative committed capital (PIC multiple)
• Residual value to since-inception paid-in capital (RVPI or unrealized multiple)

How to calculate IRR consistent with the GIPS Standards

To meet the requirements of the GIPS standards, money-weighted returns must be presented as an annualized since-inception figure that uses daily external cash flows (at least quarterly is acceptable for external cash flows prior to 1 January 2020). Additionally, stock distributions must be treated as external cash flows and must be valued at the time of distribution. For pooled funds, returns must be net of total pooled fund expenses.

While IRR is the most common money-weighted return, Modified Dietz is also an acceptable method. Not to be confused with linked Modified Dietz returns that many firms use as a time-weighted return (calculated monthly and then geometrically linked to calculate annual returns), this Modified Dietz return is calculated once covering the entire performance period.

Most firms use IRR, or more specifically, the XIRR function in Excel, which allows for daily cash flows.

One important consideration is ensuring that the return is properly annualized. If using XIRR and the period is greater than 1-year then the result of the calculation using this function in Excel is already properly annualized. If using Modified Dietz, the result is a cumulative return that will need to be annualized for periods greater than 1-year. This figure can be annualized as follows:

((1+Cumulative Modified Dietz Return)^{365/Total Days})-1

Conversely, if the XIRR is calculated for a period shorter than 1-year, it must be de-annualized. This can be done as follows:

((1+XIRR)^{Total Days/365})-1

For more information on additional considerations when presenting IRRs, i.e. money-weighted returns, in accordance with the GIPS standards, please reference the “2020 GIPS Report Utilizing Money-Weighted Returns” section of our article on presenting performance under the 2020 GIPS standards.

Questions?

If your firm is interested in claiming compliance with the GIPS standards, or would like assistance in calculating and presenting performance in accordance with GIPS, we would be happy to help.

Feel free to contact us or email Sean Gilligan directly at sean@longspeakadvisory.com with any questions.

GIPS compliant firms must make every reasonable effort to provide a GIPS Report to all prospects (excluding broad distribution pooled fund investors), regardless of whether the prospect knows about GIPS, cares about GIPS or asks for a GIPS Report.

The requirement to distribute GIPS Reports (formerly called Compliant Presentations) is not new; however, under the 2020 Edition of the GIPS standards, this rule expanded to require those claiming GIPS compliance to demonstrate that their GIPS Reports are distributed to prospects. In other words, a log of the distributions must be maintained.

Verifiers are also now required to test that this distribution is happening, so it is essential that some sort of log can be provided to your verifier to successfully get through the verification process.

If you are not prepared for this new requirement, we suggest you keep reading!

Why is Distribution of GIPS Reports a Requirement?

The fundamental aim of GIPS compliance is transparency and consistency in the way firms present investment performance to prospects. Firms providing GIPS Reports to all qualified prospects (and asset owners providing GIPS Reports to their oversight boards) improves transparency in the industry and standardizes reporting. Standardized reporting allows prospects evaluating managers with similar strategies to make the comparison easier and more meaningful.

Requiring the distribution of GIPS Reports helps get this information into the hands of prospects that may not know to ask for it but could benefit from reviewing the information prior to making their investment decision.

Who Needs to Receive a GIPS Report?

GIPS compliant firms must provide a GIPS Report to all qualified prospects. The terms “prospective client” (for segregated account prospects) and “prospective investor” (for pooled fund prospects) are defined in each firm’s GIPS policies and procedures document to ensure it is clear who must receive a GIPS Report. While firms may modify the definition to fit their sales process and business model, most firms craft this definition around two criteria:

1. The prospect has expressed interest in a particular composite/pooled fund.
2. The prospect is qualified to invest in this composite/pooled fund (i.e., they meet any applicable minimum asset levels and your firm would be willing to take them on as a client).

A prospect is required to receive a GIPS Report for the composite or pooled fund they are interested in once meeting the definition outlined in the firm’s GIPS policies and procedures. If a prospect remains a prospect for more than 12 months, the GIPS Report must be provided again since it will contain another year of annual statistics.

Current clients do not need to receive a GIPS Report for the composite or pooled fund they are invested in; however, if they become a prospect of one of your other composites or pooled funds, they must be provided with the respective GIPS Reports.

It is important to note that databases populated with composite or pooled fund performance are considered prospects and, therefore, must receive a GIPS Report. If there is no opportunity to upload the GIPS Report, then it must be sent to your contact at the database. Similarly, when responding to a request for proposal (“RFP”) that provides information for a composite or pooled fund, your response must include the GIPS Report for the strategy discussed in the RFP.

Any outside parties that market your strategies on your behalf must also be treated as prospects and receive GIPS Reports. This includes third-party financial advisors, wrap sponsors, or anyone else that sells your strategies to their clients.

GIPS Report distribution requirements are a bit different for asset owners since they do not have prospects. GIPS compliant asset owners are required to provide GIPS Reports to their oversight board at least annually.

How to Provide a GIPS Report

GIPS Reports must be delivered directly to the prospect. This can be in hardcopy or electronic form, but cannot require the prospect to navigate to find it. In other words, you can email it as an attachment or using a link that directly opens up to the GIPS Report, but you cannot simply disclose that the GIPS Reports are available on your website, requiring the prospect to retrieve it themselves.

Firms most commonly include the GIPS Report as an appendix to the pitchbook provided to prospects as a standard part of the sales process.

To be clear, you are not required to provide all of your GIPS Reports to every prospect, rather, you are only required to provide the GIPS Report for the composite or pooled fund the prospect is interested in and qualified for.

How to Create a GIPS Report Distribution Log

Maintaining a log of all GIPS Report distributions is the best way to ensure you can demonstrate that GIPS Reports are provided to all prospects. Typically, this log includes:

• Date the GIPS Report was sent
• Recipient of the GIPS Report
• Firm representative that sent the GIPS Report
• Contact information of the recipient
• Composite/limited distribution pooled fund included in the GIPS Report
• Version of the GIPS Report or file name if multiple versions are maintained
• How the GIPS Report was distributed
• Future deadlines for distribution (making sure the team sends an updated version of the GIPS Report 12 months later if the prospect is still defined as a prospect at that point in time)

There is no right or wrong way to track and monitor distribution efforts, as verifiers will accept any format that clearly demonstrates that the required distribution is taking place. It is common to leverage existing CRM systems, use excel spreadsheets or word documents to create these logs. We recommend leveraging any existing systems for tracking distribution and if none exist, use a spreadsheet (here’s a template to get you started). If you are using your CRM, make sure to tag the documentation so a report of the distributions can be exported and provided to your verifier when requested.

Remember, this is a requirement for all GIPS compliant firms and asset owners, regardless of whether they are verified or not. If you have any questions on this requirement or any other aspects of the GIPS standards, please do not hesitate to contact us.

The SEC has adopted a modernized marketing rule for investment advisers. This new advertising rule is designed to replace the outdated patchwork of guidance made through No-Action Letters and Enforcement Actions over the last several decades with principles-based provisions that are relevant to current industry practices. Advisers have 18 months from the effective date of this new rule to comply. Changes can be adopted early, but firms that adopt early must fully comply with all changes and cannot pick and choose between the old and new requirements.

The new marketing rule defines what is considered an advertisement, provides general prohibitions that are never allowed in any advertisement, sets a framework for how testimonials, endorsements, and third-party rankings may be used, and outlines what is specifically prohibited when presenting performance.

One of the key changes for presenting performance is that the new rule prohibits firms from presenting “performance results from fewer than all portfolios with substantially similar investment policies, objectives, and strategies as those being offered in the advertisement, with limited exceptions.” Despite advisers requests to continue its use, the SEC no longer allows the presentation of a single representative account.

There are two exceptions to this rule. Advisers can:

1. list the individual results of all portfolios that follow the same mandate rather than aggregating into a composite (not exactly ideal for a marketing presentation), or
2. provide performance based on an aggregation of a sample of the portfolios following the same strategy; however, the firm must support that these results are lower than if the full population had been used.

Based on these exceptions, it appears a representative account(s) may be presented, but only if the adviser can prove the performance is more conservative than that of the full composite. The only way to support this is by constructing a composite and testing if this is true. But once the composite is constructed, there is no longer a good reason to present the representative account instead. Ultimately, composites appear to be required to comply with the SEC’s new advertising rule.

While composites have historically been associated with GIPS compliance, there is no requirement for a firm to be GIPS compliant to utilize composites. With the requirements set forth in this new marketing rule, composites are likely to become much more prevalent, even with firms electing not to claim compliance with the GIPS standards.

Firms that are constructing composites for the first time may benefit from reviewing Longs Peak’s article on How to Construct Composites. Maintaining composites will essentially be required for any SEC registered firm looking to market investment performance in the future and this article helps explain how to set those composites up.

Creating and maintaining composites can have added benefits beyond just providing strategy results to present in marketing materials. Aggregating portfolios with similar investment mandates and analyzing the results can also help firms confirm that strategies are implemented consistently. Our article on Investment Performance Outlier Testing can provide some additional insight into these benefits available to firms maintaining composites.

Constructing and maintaining composites can be time consuming and difficult to manage without errors. Longs Peak specializes in setting up policies and procedures for composite construction as well as following those policies and procedures to implement and maintain composites for our clients. Reach out to us today to discuss how we can help your firm create and maintain composites.

There are two types of returns investment managers use to report the performance of their strategies: Time-Weighted Returns (“TWR”) and Money-Weighted Returns (“MWR”). The most common MWR is the Internal Rate of Return (“IRR”). Here we take a look at both TWR and MWR to help you understand when each method should be used and why.

The key difference between the two methods is that:

• Time-Weighted Returns REMOVE the effect of the timing and amount of external cash flows.
• Money-Weighted Returns INCLUDE the effect of the timing and amount of external cash flows.

Because of this, money-weighted returns represent the actual return received by the investor, while time-weighted returns represent the return achieved by the investment manager after removing the effect of external cash flows.

But when is it appropriate to use one over the other? Because MWRs reflect the investor’s actual returns, it may seem like the best method to use in all situations. However, if the purpose of reviewing the performance is to evaluate the portfolio manager’s discretionary management, we do not want decisions made by the investor to affect the results. The most appropriate methodology to use to evaluate the portfolio manager depends on who controls the external cash flows (contributions and withdrawals) from the portfolio.

Investor-Driven Cash Flows

When the timing and amount of external cash flows are controlled by the investor, investor-driven decisions impact the return. To present returns that allow investors to evaluate a manager’s discretionary management, TWR should be utilized to remove the effect of these investor-driven decisions. Because the effects of cash flows are removed, a TWR doesn’t penalize or benefit a portfolio manager’s performance for contributions or withdrawals that the manager did not control.

Investment Manager-Driven Cash Flows

When the investment manager does have control over the timing and amount of external cash flows (e.g., private equity funds where the investment manager has control over capital calls and distributions), their effects should be included in the evaluation of the manager’s performance. An MWR, which includes the effect of timing and amount of external cash flows, would therefore appropriately penalize or benefit a portfolio manager for contribution and withdrawal decisions that were part of their discretionary management.

External Cash Flow Impact on Returns

Without external cash flows, TWR and MWR are equal. When external cash flows (and volatility) are present, the results will differ.

The following are examples of how the MWR and TWR will differ under different market scenarios:

1. If a contribution is made and then the portfolio has subsequent performance that:
   • SHIFTS POSITIVELY – MWR > TWR (investor added money just before the upswing)
   • SHIFTS NEGATIVELY – TWR > MWR (investor added money just before the decline)
   • REMAINS STEADY – TWR = MWR (investor added money during a period without volatility)
2. If a distribution is made and then the portfolio has subsequent performance that:
   • SHIFTS POSITIVELY – TWR > MWR (investor withdrew money just before the upswing)
   • SHIFTS NEGATIVELY – MWR > TWR (investor withdrew money just before the decline)
   • REMAINS STEADY – MWR = TWR (investor withdrew money during a period without volatility)

To help visualize how this works, below are three examples. For the sake of simplicity, we assume the portfolio perfectly replicates the index. The line on the graphs demonstrates the index return stream for the performance period while the filled in area represents the amount of capital invested during each segment of the period. Since TWR removes the effect of the external cash flows, the TWR will approximately equal the index return while the MWR will be impacted by the amount of capital invested for each segment of the performance period.

Example 1: A portfolio with a beginning value of $100k has a steady return of 10% without any volatility for the full period (scenarios with and without external cash flows):

The TWR and MWR is equal for all of these scenarios because there is no volatility. With a steady return stream, there is no market timing that would make external cash flows cause a difference between the TWR and MWR.

Example 2: A portfolio with a beginning value of $100k has a 10% increase, but subsequently declines to end the period at the same level at which it began.

The TWR is 0% for all scenarios because the strategy lost all of its initial gains to end up back at the starting point.

The MWR is negative when adding money at the high point because in this scenario the capital base is smaller while the strategy is performing positively and larger when the strategy is performing negatively.

The MWR is positive when removing money at the high point because in this scenario the capital base is larger while the strategy is performing positively and smaller when the strategy is performing negatively.

Example 3: A portfolio with a beginning value of $100k has a 10% decrease, but subsequently increases to end the period at the same level at which it began.

The TWR is 0% for all scenarios because the strategy gained back all of its initial losses to end up back at the starting point.

The MWR is positive when adding money at the low point because in this scenario the capital base is smaller while the strategy is performing negatively and larger when the strategy is performing positively.

The MWR is negative when removing money at the high point because in this scenario the capital base is larger while the strategy is performing negatively and smaller when the strategy is performing positively.

Criteria to Determine When MWR is Appropriate

Ultimately, investment managers should be evaluated based on TWR unless specific criteria are met, in which case MWR is more appropriate. The criteria[1] for using MWR includes:

The investment manager has control over the timing and amount of external cash flows and the investment vehicle has at least one of the following characteristics:

• Closed-end
• Fixed life
• Fixed commitment
• Illiquid investments as a significant part of the investment strategy

MWR vs TWR for GIPS

The use of money-weighted returns in GIPS Reports instead of time-weighted returns has broadened under the 2020 edition of the Global Investment Performance Standards (“GIPS”). All firms can show MWRs in addition to TWRs if they wish to do so; however, if a firm wishes to replace its TWR with MWR, the criteria listed in the prior section must be met. For more information on these requirements, please see Question 10 of Longs Peak’s GIPS Compliance FAQs.

For more information on how to present performance information in compliance with the GIPS standards, see our recent article on updating GIPS reports to comply with the 2020 edition of the GIPS standards.

If you have questions about calculating investment performance or GIPS compliance, please contact us or email Sean Gilligan at sean@longspeakadvisory.com.

[1] Global Investment Performance Standards (GIPS®) – For Firms, Fundamentals of GIPS Compliance, Provision 1.A.35, pages 5-6.

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.