How to Construct Composites

GIPS compliant firms are required to calculate and present composite performance, rather than presenting the performance of a model or single representative account. The purpose of this is to ensure investment managers are presenting an accurate representation of their ability to implement a strategy, rather than “cherry-picking” their best performing portfolio. As discussed in our previous 2-part blog post, about how to create a GIPS Policies & Procedures Document, composites must be defined based on the strategies your firm manages. Once your composites are defined and composite rules established, you are then ready to construct your composites.



Organize Portfolios by Strategy

A composite is an aggregation of portfolios with similar objectives. The first step in constructing composites is to group all of the portfolios your firm manages by strategy, which will later be refined by applying composite rules. Strategies can be as broadly or narrowly defined as you like as long as the resulting performance statistics are meaningful. If you are not sure how to define your firm’s strategies, you should consult with a GIPS expert to ensure the definitions maximize the marketing opportunities available to your firm. Most importantly, you should ensure that they are:

  1. Representative of how your strategies are managed and how you intend to market your firm’s offerings.
  2. Broad enough to have sufficient assets that may be required to attract certain institutional investors.
  3. Narrow enough that the dispersion is low and the performance results are meaningful.
  4. Easily comparable to the strategies marketed by your firm’s closest competitors.

When grouping your portfolios into strategies, you must consider both the portfolio’s current mandate as well as historical changes in your clients’ investment policy statements. If a portfolio’s strategy has changed since inception, you must check that it is grouped under the correct strategy both before and after the change.


Apply Composite Rules

Once portfolios are grouped by the strategy they followed for each period, you can then apply your firm’s composite rules established in your GIPS Policies and Procedures document (“GIPS P&P”) to create each strategy’s corresponding composite. For example, if you have a U.S. Large Cap Growth strategy, you can start by evaluating all of the portfolios that follow this strategy’s definition. If the portfolio meets your firm’s GIPS definition of discretion and does not break any other composite rule (such as minimum asset level), the portfolio can be added to your U.S. Large Cap Growth composite.

The timing of the portfolio’s inclusion in the composite will be based on the inclusion policy set in your firm’s GIPS P&P (e.g., the first full month after the portfolio is funded or the first full month after the portfolio is at least X% invested). The portfolio will then remain in the composite until discretion to implement this strategy is lost, at which point the portfolio will be excluded from the composite based on the exclusion policy set in your firm’s GIPS P&P (e.g., the end of the last full month before discretion was lost).


Discretion to implement this strategy can be lost one of the following ways:

  1. The client adds a restriction to the portfolio causing it to no longer meet your firm’s definition of discretion – The portfolio becomes non-discretionary until the restriction is lifted or until the restriction no longer interferes with the implementation of the strategy.
  2. The client notifies your firm that they will be terminating your management of the portfolio – The portfolio is closing and is considered non-discretionary until the assets transfer out.
  3. The client requests a change to a different strategy – The portfolio is temporarily non-discretionary as it is rebalanced to fit the new strategy, at which point it will enter the new strategy’s composite based on its inclusion policy documented in your firm’s GIPS P&P.
  4. The client makes a deposit or withdrawal of cash or securities that exceeds the composite’s defined “significant cash flow” threshold – The portfolio is temporarily non-discretionary as trading takes place to facilitate the client-requested cash flow and the portfolio will be re-included in the composite based on the timing documented in your firm’s significant cash flow policy.
  5. The portfolio’s market value drops below the composite’s documented minimum asset level – The portfolio becomes non-discretionary until the market value goes back above the composite’s minimum asset level, at which point the portfolio would be considered discretionary again and would be re-included in the composite based on the timing documented in your composite’s minimum asset level policy.

It is important to note that the first four of the five scenarios listed above are driven by client requests and the fifth is based on a predetermined policy. The removal of a portfolio from a composite cannot be based on changes made to a portfolio that are driven by the portfolio manager. If a portfolio manager makes a tactical shift in the strategy, such as holding higher cash because of current market conditions, this would be considered an evolution of the strategy definition rather than a reason to remove an account from the composite.


Conduct Tests Before Finalizing Compsites

The process of reviewing portfolios to ensure they are placed in the correct composite for the right time period can be difficult. Many firms rely on GIPS consultants or composite software to help test their composites to identify portfolios that break composite rules or exhibit outlier performance (indicating that a portfolio may not belong in the composite). Being proactive about composite testing allows you to make corrections before finalizing composite results for distribution or verification.

Best practice is to address these issues when building the composites rather than waiting for issues to be caught during the verification process. Often, when issues come up during verification, it leads to an increase in the verification testing sample size, resulting in more work and potentially more cost to complete the verification.


Calculate Composite Statistics

Once your composite membership is finalized, you can then calculate composite statistics. Specifically, you will need to calculate annual composite performance, a measure of internal dispersion, and three-year annualized ex-post standard deviation. The calculation methodology used must be consistent with the methodology described in your firm’s GIPS P&P.

We will discuss each of these statistical measures as well as well as the other figures and disclosures that must be included in a GIPS compliant presentation in the final part of this blog series “How to Create GIPS Compliant Presentations.” Please subscribe to our blog or follow us on social media to ensure you don’t miss the conclusion and to receive future GIPS and performance-related educational updates.


Want to Learn More?

If you have any questions about the GIPS Standards, we would love to help.  Longs Peak’s professionals have extensive experience helping firms become GIPS compliant as well as helping them maintain compliance with the GIPS Standards on an ongoing basis. 

Part 1: Creating GIPS Policies and Procedures

Firm Definition and Definition of Discretion

GIPS compliant firms are required to document how they comply with the GIPS requirements as well as any recommendations that the firm chooses to follow. This document acts as the firm’s internal representation of their GIPS compliance, and is intended to state the firm’s policies and describe the procedures the firm follows to maintain its compliance.



Many firms create their GIPS policies and procedures (“GIPS P&P”) from a template; however, unless this template is customized to address the unique circumstances of the firm, it will not sufficiently describe the firm’s actual practices in place to adhere to the GIPS requirements. Given that every firm has their own unique set of circumstances, we cannot cover every detail that your GIPS P&P should include, but we will cover the most important parts that every firm is required to document. Within Part 1 of this two part series we will focus on Firm Definition and Definition of Discretion. In Part 2 we will cover calculation methodology, books and records, composite definition, and error correction.


Firm Definition

The GIPS standards must be applied to your firm as a whole, not to a single product or strategy you manage. How your firm is defined for GIPS purposes is primarily based on how the firm is held out to the public, which may differ from the legal structure of your firm.

Most small and mid-sized investment managers define their firm for GIPS purposes the same as they are defined for legal and regulatory purposes. If you choose to define your firm more narrowly than the legal entity, it is important to ensure that you will be able to clearly and consistently hold yourself out to the public based on this more narrow definition. Most importantly, you must never imply that any part of your firm that falls outside of your GIPS Firm Definition is GIPS compliant.

Your GIPS P&P must include a written definition of your firm. This definition will then be provided as a disclosure in each of your firm’s GIPS compliant presentations. The following are a couple examples of how one might define their firm:

Example 1 – Firm Definition Matches Firm’s Regulatory Registration

ABC Asset Management, LLC is a registered investment advisor with the United States Securities and Exchange Commission in accordance with the Investment Advisors Act of 1940. ABC Asset Management, LLC manages equity and fixed income strategies for institutions and high net worth individuals.

Example 2 – Firm Defined More Narrowly than the Firm’s Regulatory Registration

ABC – Institutional is the Institutional Division of ABC Asset Management, LLC, which manages equity and fixed income strategies for institutional investors. ABC Asset Management, LLC is a registered investment adviser with the United States Securities and Exchange Commission in accordance with the Investment Advisers Act of 1940. ABC Asset Management, LLC also includes a wealth management division focused on managing customized portfolios for high net worth individuals. The institutional and wealth management divisions are held out to the public as separate entities and only the institutional division complies with the GIPS standards.


Definition of Discretion

One of the benefits of GIPS is that it helps your firm demonstrate its ability to manage each strategy that it offers. To ensure that your composite results truly reflect your portfolio manager’s decision-making process, it is important to include only the accounts that are free of material, client-mandated restrictions in your composites.

GIPS requires all discretionary, fee-paying portfolios to be included in at least one composite, while non-discretionary portfolios are excluded from composites. Within your GIPS P&P you can define how to determine the discretionary status of each account.

The term “discretion” is defined differently for GIPS than it typically is for legal or regulatory purposes. For example, you may have a discretionary contract for an account that you deem to be non-discretionary for GIPS purposes because of restrictions the client places on the implementation of the strategy. The definition of discretion section of your firm’s GIPS P&P should outline objective criteria for determining the discretionary status of accounts.

This section typically includes the types of restrictions that would cause an account to be deemed non-discretionary for GIPS purposes. Ideally, firms should include thresholds to ensure the policy can be followed consistently. For example:

  • Custom allocation requests that cause the portfolio’s asset allocation to deviate by more than 10% from the strategy’s target allocation.
  • Restricting the purchase or sale of certain securities that affects more than 10% of the portfolio.
  • Requests to hold cash at a level more than 5% above the current cash target.
  • Monthly, recurring cash flows regardless of size.
  • The use of margin, regardless of amount used.

As far as determining the thresholds to set, firms that manage their strategies very strictly to a model will typically have very low thresholds or even a 0% tolerance for deviations from their model. These deviations would trigger the portfolio to be deemed non-discretionary and excluded from the composite. Firms that allow for greater customization in their portfolio construction will typically have a higher tolerance for deviations.

When setting the criteria for determining discretion you’ll want to consider the following:

  1. A greater tolerance for deviations from the strategy’s holdings/allocation, will result in more portfolios in the composite (higher disclosed composite size), but dispersion (differences in performance between portfolios in the same composite) will also be higher.
  2. A lower tolerance for deviations results in tighter dispersion, but composite assets will be smaller and your firm’s number of non-discretionary accounts will be larger.

Your firm should find a balance that results in composite performance that meaningfully reflects the size and dispersion of your strategies.


Want to Learn More?

If you have any questions about the GIPS Standards, we would love to help.  Longs Peak’s professionals have extensive experience helping firms become GIPS compliant as well as helping them maintain compliance with the GIPS Standards on an ongoing basis. 

What are the GIPS Standards?

The Global Investment Performance Standards (GIPS®) are an ethical framework that standardize how investment managers calculate and report their investment performance to prospective investors. Standardized presentations help ensure the information presented is meaningful, complete, and comparable to performance presentations of other GIPS compliant firms, regardless of location or regulatory jurisdiction.

This comparability helps simplify the due diligence process for prospective investors as it allows them to make an “apples-to-apples” comparison of similar strategies managed by different investment managers regardless of their location. Currently, there are 37 countries that have officially adopted GIPS, making it a true global standard.


Why are the GIPS Standards Necessary?

GIPS is designed to address potentially misleading practices employed by some investment managers when presenting investment performance to prospective clients. Examples of misleading practices include:

  • “Cherry-picking” accounts – Showing a strategy’s best performer as a representation of how the strategy performed as a whole
  • Using selective time periods – Presenting the performance of a strategy only for the period it performed the best
  • Utilizing model or back-tested results when results of actual managed accounts could have been used
  • Survivorship bias – Excluding accounts that have closed (often the worst performing accounts) from performance calculations

Under GIPS, discretionary accounts are grouped into composites based on the strategy they follow. Performance is then reported at the composite level, based on the aggregation of the accounts within the composite. Composites only include actual discretionary accounts, not models, and it is required to present each composite’s performance statistics for each annual period.

These requirements, implemented in conjunction with the rest of the GIPS requirements, help prevent compliant firms from manipulating their results and improve comparability between firms that are GIPS compliant and manage similar strategies.


Why Become GIPS Compliant?

GIPS compliance offers investment managers both marketing and compliance benefits.

According to eVestment, two out of three searches made in their database by investors or consultants are set to exclude firms that are not GIPS compliant. Being able to “check the box” in RFPs and consultant databases indicating that your firm is GIPS compliant can be a valuable marketing benefit.

Being GIPS compliant requires firms to document policies and procedures, addressing how their firm complies with all of the GIPS requirements as well as the recommendations they choose to adopt. The practice of documenting and implementing these policies is an excellent way to ensure your firm is consistent in its practices across the firm, which can be immensely valuable to your compliance department.


Misconceptions About GIPS that Discourage Managers from Complying

Misconception 1: GIPS Compliance is Burdensome and Expensive

The initial process of becoming compliant can be time consuming; however, if sufficient time is put in at the start of the process to create detailed GIPS policies and procedures and construct composites that consistently follow these policies, the ongoing maintenance is very manageable.

For firms that do not have the resources available internally to bring their firm into compliance, GIPS consulting firms such as ours, Longs Peak Advisory Services (“Longs Peak”), are available to assist with the creation of policy documents, construction of composites, the creation of compliant presentations, etc.

Verification is often the largest direct expense associated with GIPS compliance; however, having your firm verified is not required. If you choose to be verified, the marketing benefit received will likely outweigh the cost. If the cost of a verification is more than your firm can currently afford, you can always become complaint now and add verification at a later date when it fits more comfortably in your budget.

If a firm can comply with all of the GIPS requirements without the help of a GIPS consultant and elects not to have their compliance verified, there is no direct cost for a firm to be GIPS compliant.


Misconception 2: GIPS is Not Relevant for My Firm

As mentioned earlier, GIPS offers both marketing and compliance benefits. Even if you are not marketing your strategies to institutional investors that require their managers to be GIPS compliant, your firm can still benefit from GIPS. More specifically, if your firm:

Only manages funds:

It may seem pointless to create a composite of one account; however, when marketing a composite rather than the fund itself, adjustments can be made to the fund’s fees to make the performance results more representative of what a separate account would have experienced following your strategy. This composite performance could be used to market your strategy to prospective separate account investors or to help prospective clients compare your performance to a competitor whose performance is based on a composite of separate accounts.

Manages customized portfolios:

Even if you are not managing a strategy strictly to a model, composites can be built based on the risk level of the client. For example, many wealth management firms have Conservative, Moderate, Growth, and Aggressive composites. There may be some dispersion between accounts within each composite, but these composites at least give you the opportunity to present an aggregation of your actual accounts with similar risk and objective profiles.


Questions?

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