Part 1: Creating GIPS Policies and Procedures
Sean P. Gilligan, CFA, CPA, CIPM
June 6, 2017
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.
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:
- 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.
- 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.
Updates for GIPS 2020
The GIPS standards were updated in 2020. Check out our post How to Update Your GIPS P&P for GIPS 2020 to make sure your P&Ps are consistent with these changes.
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.