Exploring and Documenting Consistent Calculation Methodologies

Exploring and Documenting Consistent Investment Performance Calculation Methodologies

When trying to understand the limits of the SEC Marketing Rules requirements for consistent related account performance calculation methodologies, advice circulating that firms cannot link daily and monthly performance valuations is misguided. Established in 1993, a key objective of the GIPS® Standards 30-year framework, referenced throughout the SEC Adopting Release, is to “ensure uniformity in reporting so that results are directly comparable among investment managers.”¹ In 2022, compliance with the GIPS standards establishes that consistent calculation methodologies and changes over time are not mutually exclusive, and the GIPS standards also set a best practice precedent for documenting prospective methodology changes and keeping the history intact.

In this article, we explore different methodologies over time, among related account performance calculations, and what different methodologies aren’t permitted in the SEC Marketing Rule.

Individual firms are encouraged to raise the bar on a prospective basis as technology permits. The GIPS standards themselves have prospectively changed both valuation and calculation methodology requirements, keeping historical requirements intact. The documentation of historical changes are contained throughout the GIPS Standards, with illustrative provisions 2.A.24 and 2.A.25 included below.

Examples include the transition from quarterly to monthly valuations in 2001, requiring trade date accounting in 2005, and using fair values instead of market values in 2011. A firm’s historical performance is not only still permitted to be shown for GIPS compliant firms using historical methodologies after there is a prospective change in the GIPS Standards, a ten-year record is required to be maintained, and restating historical performance is to be avoided.

Although the SEC Marketing Rule Adopting Release doesn’t prescribe specific valuation periods or calculation methodologies the way the GIPS standards do, the Adopting Release allows for related accounts to contain immaterial differences in performance calculations.  When discussing the ability to include or exclude accounts from the related account prescribed time-period performance, the SEC gives “advisers additional flexibility to present related performance when there may be immaterial differences in performance results depending on the methods of calculation of returns or as between the different prescribed time periods.”²

This guidance indicates that it is permissible to group related accounts that utilizing more than one calculation methodology for performance.  Further, the Adopting Release states that a firm may “use the same criteria to construct any composites to meet the GIPS standards in order to satisfy the ‘substantially similar’ requirement of the Marketing Rule’s definition of ‘related portfolio.’”³ The GIPS Standards require accounts to be included in composites if they are managed to the same strategy, and specifically permit different calculation methodologies between pooled funds and segregated accounts within the same composite. From a discussion in the 2020 GIPS Standards 2.A.164:

“Although a firm must establish a composite-specific or pooled fund–specific calculation policy, that policy may differentiate calculations used for different types of portfolios in the composite. For example, suppose that a firm has a composite that includes pooled funds, which use a daily TWR calculation methodology, and segregated accounts, which use a Modified Dietz return (with revaluations for large cash flows) calculation methodology. The firm may have a different policy for the return calculation methodologies used for pooled funds versus segregated accounts that are included in the same composite. The firm must apply the composite-specific calculation policy consistently, however, based on the return calculation methodology for each type of portfolio in the composite.”

“Policies and procedures should be reviewed regularly to determine if they should be changed or improved, but it is not expected that they will change frequently. A firm must not change a policy retroactively solely to increase performance or to present the firm in a better light. Retroactive changes to policies and procedures should be avoided.”5

Any advice that firms will not be able to link monthly Modified Dietz performance with daily performance may have been taken out of context, perhaps from the following passage from the rule: “… net performance must be calculated over the same time period, and using the same type of return and methodology as, the gross performance.”

This passage requires that gross returns and net returns are presented using the same calculation methodology as one another.  This does not require the methodology used to calculate both net and gross returns to remain the same over a period of time, as discussed above.  For example, the rule prohibits gross performance from being calculated using the Modified Dietz method, if net performance is calculated by linking daily performance, but the rule does not prohibit a portion of the track record for both gross and net returns from being calculated with Modified Dietz, while another portion of both gross and net are calculated by linking daily performance. Another example of a prohibited calculation methodology would be if gross returns were presented as time-weighted returns and net performance was presented as money-weighted returns.

In conclusion, Modified Dietz, Modified Dietz plus subperiod revaluations for large cash flows, and daily valuations are all acceptable methods for calculating time-weighted returns. Linking any of those three methodologies over time as the GIPS standards have evolved (and portfolio accounting system functionality has evolved) is a common practice in almost every GIPS compliant performance record presented over the past 30 years.  There are many unanswered questions when implementing the SEC Marketing Rule, but the permissibility of calculation methodology changes isn’t one of them.  Documentation and disclosure of changes is all part of a consistent calculation methodology for firms to be able to show meaningful performance that spans decades while also being able to adapt as technology continues to advance and performance calculations become more sophisticated.

Cascade Compliance has over 34 years of combined experience working with SEC Regulations, the GIPS standards, and performance.  Our employees have worked with hundreds of firms in the U.S. and abroad.  One of the best parts of working with clients is getting to share expertise and knowledge of best practices across the industry.  Whether you are a client of ours or not, we are here to help you get better at what you do and answer any questions you may have.  Contact us at connect@cascadecompliance.com.

¹Performance Presentation Standards, AIMR, 1993, (p. ix)

²Investment Advisor Marketing, 17 CFR Part 275 and 279, SEC Final Rule, 2021 Adopting Release, (p. 189)

³Investment Advisor Marketing, 17 CFR Part 275 and 279, SEC Final Rule, 2021 Adopting Release, (p. 194)

4GIPS Standards Handbook, CFA Institute, 2020, (p. 90)

5Investment Advisor Marketing, 17 CFR Part 275 and 279, SEC Final Rule, 2021 Adopting Release, (p. 319)