Exploring and Documenting Consistent Calculation Methodologies

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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)

SEC Marketing Rule – Hypothetical & Extracted Performance

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Hypothetical performance and extracted performance are a key point in the SEC Marketing Rule set to take effect on November 4, 2022.  Firms that have previously used model, targeted, projected, and back tested performance need to take special care when presenting such performance to prospective clients.  The new rule is a significant change from what a lot of firms have been previously allowed to do.

Hypothetical performance will only be allowed after November 4, 2022, if the advisor takes specific steps to address its potentially misleading nature. The SEC’s goal with this portion of the rule is to ensure that advertisements containing hypothetical performance are only distributed to investors who have the financial expertise and resources to interpret the data and understand the risks and limitations of these types of presentations.

There is no distinction between retail and non-retail investors in the new rule when considering the sophistication of the audience receiving the hypothetical performance). The only exception to the hypothetical performance rule is one-on-one communications provided in response to unsolicited investor requests or provided to a private fund investor.

What is considered hypothetical performance?

Hypothetical performance is defined as performance results that were not achieved by any portfolio of the investment advisor. Hypothetical performance includes, but is not limited to: model performance, backtested performance, and targeted or projected performance returns.

Model performance includes performance where the advisor applies an investment strategy that is similar to an actual investor account but makes slight changes to the model to accommodate different investor objectives. Computer generated models are included in the definition of model performance. This type of performance was originally described in the Clover Capital No Action Letter.

Backtested performance is performance that has had a strategy applied historically to market data from prior periods when the strategy was not actually used. This includes scenarios where an advisor could backtest performance based on current strategy data and apply it historically either because the manager doesn’t have actual portfolios during the period, or because the manager doesn’t have access to portfolio books and records for the past period.

Targeted and Projected performance reflects an advisor’s aspirational performance goals. These returns reflect an advisor’s performance estimates, often based on historical data and assumptions. Projections of general market performance or economic conditions are not subject to the provision on presentation of hypothetical performance.

What’s New

  1. The advisor must create and implement policies and procedures designed to ensure the performance information provided is relevant to the financial situation and investment objectives of the intended audience of the advertisement. These policies do not need to address each specific recipient’s circumstances but rather the likely investment objectives and financial situation of the advertisement’s intended audience. Being thoughtful in your establishment of policies and procedures that connect your firm’s hypothetical performance as a useful tool for your typical clients is a key step in being ready for November 2022.

What’s Familiar

  1. The performance being presented must be net performance—just like all actual performance beginning November 2022.
  2. An advisor must provide sufficient information to the intended audience to enable them to understand the criteria and assumptions used in calculating the performance. Sufficient information includes details about how the hypothetical performance is calculated and describes any assumptions used.
  3. An advisor must provide (or offer to provide if the audience is a private fund investor) sufficient information that enables the intended audience to understand the risk and limitations of using hypothetical performance in making investment decisions. Risk information should include reasons why the hypothetical performance might differ from actual performance of a portfolio. An example of this would be external cash flow timing. Simply disclosing the possibility of loss is not enough to satisfy this requirement.

Hypothetical Performance Example

Below is sample disclosure language pertaining to risk information for prospective clients and investors to understand the hypothetical performance shown.  Much of the sample language is straight from rescinded SEC no-action guidance, and we expect such guidance to live on in the implementation of the new Marketing Rule.  While there are familiar disclosures below, we encourage firms to be thoughtful in considering the variety of reasons that their hypothetical performance may differ from actual performance.

The presented performance represents hypothetical model results during the measurement time period. As such, these results have limitations, including, but not limited to, the following:

  • model performance may not reflect the impact that material economic conditions and market factors would have had on the adviser’s decision making or on individual clients, or the impact of the timing of actual client cash flows into or out of an actual portfolio;
  • results do not reflect actual trading by specific clients, but were achieved by [describe calculation methodology and material objectives or strategies used to obtain results];
  • model performance does not reflect brokerage commissions, custodian fees, taxes, or any other expenses a client would have paid, and as such, actual investment returns would be lower;
  • how (if) model performance reflects investments that differ from advisory services currently offered; and
  • hypothetical past performance [just like actual past performance] is no guarantee of future results.

One final note on hypothetical that bridges both policies and disclosures pertaining to hypothetical performance: with the new requirement to show related account performance for actual accounts, now more than ever, it is important to have policies and procedures for reviewing actual portfolio performance to results portrayed in a model.  Results that are materially similar will lend credibility to the usefulness and relevance of the hypothetical/model performance.  Alternatively, we recommend firms reconsider using model performance where model results materially differ from the actual results of related accounts, nor can firms use model results as a replacement for doing the difficult work of aggregating related account performance histories.

Extracted Performance

Extracted performance is defined as performance results of a subset of investments extracted from a single portfolio. This type of performance is commonly known as a “carve-out” to firms that comply with the Global Investment Performance Standards (GIPS®). Additional requirements will apply to advisors who present this type of performance.

The advisor must provide, or offer to provide promptly, the results of the total portfolio from which the extracted performance was derived. This is intended to prevent advisors from cherry-picking certain performance results.

Performance that is extracted from a composite of multiple portfolios is not considered extracted performance because it is not a subset of investments extracted from a single portfolio. This type of performance (including carve-out composite performance that complies with the GIPS Standards) is considered hypothetical and will be subject to the hypothetical requirements discussed above.

The final rule does not require a specific treatment for cash allocation in extracted performance. However, it would be considered misleading to not disclose the allocation of cash and the effects of the cash allocation, or the absence of a cash allocation. When crafting disclosures to meet the SEC rule, it’s important to consider the intended audience. For firms claiming compliance with the GIPS Standards,  cash allocations and additional disclosures are required.

With the SEC Marketing Rule, please remember that when performance is shown, firms must show performance as net of fees.  Firms can also show gross of fee performance however, net must be shown in equal prominence.

Read our blog on SEC portability and predecessor performance here.

If you have any other questions regarding the marketing rule, contact us here.

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.

 

SEC Marketing Rule – Prescribed Time Periods

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The modernization of the SEC Marketing Rule has firms hard at work to comply with new requirements related to the presentation of performance. One of these requirements is referred to as Prescribed Time Periods, where a firm must present a 1-, 5-, and 10-year net returns in any of its marketing materials that show performance. This level of prescription is a significant departure from the SEC’s past performance disclosure requirements.  Similar to the GIPS Standards®, this requirement is particularly valuable in that it prevents firms from presenting only the best time periods and also provides prospective clients comparable short-term and long-term performance figures across RIAs. Below, Cascade outlines the requirements for presenting the prescribed time periods, and what this will mean for GIPS Compliant firms.

Presentation Requirements

Beginning November 4, 2022, all performance presented in an SEC-registrant’s marketing materials must include the additional time period requirements. Private funds are currently exempt from the prescribed time periods; however, there is a proposed rule that would require the same time periods for liquid private funds for their current investors.

One-, five- and ten-year net performance must be included in marketing materials when presenting performance. For strategies without ten (or five) years of performance, a since inception return is required. The SEC Marketing Rule does not specify whether cumulative or annualized returns are to be used when calculating these returns. Cascade recommends annualized returns for easier comparison to annual performance and for consistency with industry best practices.

All returns must be updated through an end date no less recent than calendar year-end. The one caveat is if there has been an event which has had a significant negative effect on performance. In that case, performance through the most recent quarter-end is required (if available). If the most recent quarter-end performance is not available, the adviser should include appropriate disclosure on the performance that is presented.

As of now, it’s expected of firms to have updated performance numbers on marketing materials within one month of year-end (or quarter-end when there’s been significant negative performance as mentioned above). While this is not explicitly stated in the SEC’s marketing rule document, it was addressed in an April Q&A which can be found here. If your firm has illiquid products, stay tuned. Future SEC guidance for illiquid investment performance is expected, and we will update this article when/if additional guidance is released for updating performance.

Implications for GIPS Compliant Firms

If your firm claims compliance with the GIPS standards and is SEC registered, additional requirements will apply. Showing a GIPS Report with 10 years of performance is not a substitute for the prescribed time period requirements. Each firm will need to consider how they present their GIPS Report to prospective clients to better understand their options for presenting the SEC required prescribed time periods.

  • If the GIPS Report is used as a standalone advertisement, 1-, 5- and 10-year net returns must be added to meet the SEC requirement.
  • If the GIPS Report is included as part of a pitchbook, the 1-, 5- and 10-year returns can be presented on a separate page.

Another important consideration is that the GIPS Standards require the presentation of benchmark returns for the same periods that composite returns are presented. If your firm claims compliance with the GIPS standards and adds 5- and 10-year composite gross and net returns to the GIPS Report, benchmark returns must also be shown for those same periods. Further, if your firm follows the GIPS Advertising Guidelines, a 3-year annualized return for the composite and benchmark is required in addition to the 1- 5- 10-year SEC prescribed time periods. Remember that everything on the GIPS Report is subject to your firm’s GIPS error correction policies, including the 5-, and 10-year returns, if added. We recommend firms add error correction policies and procedures for the prescribed time periods, should a firm include them in the GIPS Report.

Example 1-, 5-, and 10-year returns:

If you would like to receive a copy of our template for calculating annualized and cumulative performance, or have any other questions regarding the marketing rule, contact us here.

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.

Want to Show Performance and Not GIPS-Compliant?

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The SEC Marketing Rule will require SEC-registered firms to have policies and procedures in place be able to show performance in marketing materials after November 4, 2022. For firms not claiming compliance with the GIPS Standards this could be challenging. This article will help you get a start on what is required and what is not.

Related Performance

The finalized rule requires the use of related net performance in advertisements, if performance is presented. This can be presented on a portfolio-by-portfolio basis or as a composite aggregation of all related portfolios. The rule does not specify which criteria should be used to determine related portfolios but requires advisors to document policies and procedures detailing the criteria used for including performance of all substantially similar portfolios. A portfolio may be excluded if the resulting performance results are not materially higher than if all related portfolios were included.

Where should a firm begin?  We’ve outlined some steps below:

  1. Define the firm’s strategies and which accounts should be grouped together for the minimum 10-year history.
    • Determine how many strategies the firm has and wants to market
    • Look at investment policies and objectives across the accounts
    • Decide which accounts are similarly managed
  2. Determine inclusion/exclusion policies
    • Inclusion: When an account opens the firm gets to decide a consistent policy for including accounts into the related performance. Some items to consider:
      • How long does it take to invest the account in the strategy?
      • Is there a percentage threshold for including accounts that have some assets not invested to the strategy?
    • Exclusion: When an account closes or changes strategies/guidelines, the firm gets to decide a consistent policy for excluding accounts from the related performance. Some items to consider:
      • Most firms choose to exclude accounts after the last full month under management of the strategy
      • Other options: quarterly exclusion, which is more common for illiquid strategies
  3. Determine and document the calculation methodology used for calculating portfolio level performance. The SEC Marketing Rule specifically referenced the GIPS Standards as an acceptable framework. However, each firm needs to consider the resources available to them.  Methodologies listed below are commonly used in the industry, and the first two are used by GIPS compliant firms most frequently:
    • Daily performance using modified Dietz method
    • Monthly performance using modified Dietz method with large cash flows revalued on the date of the cash flow
    • Internal Rate of Return
  4. Determine and document the calculation methodology used for the related performance and what the performance intervals (monthly, quarterly, annually) will be.
    • Most firms use a monthly asset weighted methodology
    • Firms with composite management systems can also use an aggregate method
    • While not allowed in the GIPS standards, firms might be able to use an equal weighted method
    • Present all individual portfolio returns for the required periods

For firms currently showing representative account performance, the new rule now requires policies and procedures as well as an analysis for determining that the single representative account returns shown are not material different than other accounts invested to the strategy.  The SEC wants to make sure firms are not cherry-picking accounts and showing their best performance.

Prescribed Time Periods

Once the firm has calculated related performance, the next item is required time periods of returns. If performance is shown, all advertisements must present 1-, 5- and 10-year net returns, with an end date no less recent than the most recent calendar year end. If the track record presented is shorter than 10 years, a since-inception return is required.

 

 

 

Firms will be expected to update returns through the most recent year end by 1/31 on all marketing materials. If gross of fee returns are shown, net returns must be presented with equal prominence and can be shown alongside returns for additional time periods if the firm chooses to present additional time periods.

The SEC does not specify whether cumulative or annualized returns must be used. Our recommendation is to use annualized returns to be more meaningful to prospective clients and align with the GIPS Standards advertising requirements. Either calculation is straightforward to do in Excel if you have monthly returns for the period.  See the formulas below if you want to try this at home.

5-year cumulative return =PRODUCT(1+MonthlyReturn1:MonthlyReturn60)-1
5-year annualized return =(PRODUCT(1+ MonthlyReturn1:MonthlyReturn60))^(1/5)-1

Extracted Performance

Extracted performance is defined as performance results of a subset of investments extracted from a portfolio. Under the final rule, extracted performance may be presented in an advertisement if certain conditions are met. The firm must disclose any differences between the total portfolio and the extracted performance and provide or offer to provide results of the total portfolio.

There is no prescribed methodology for the treatment of cash allocation within the extracted performance. Depending on the type of extracted performance, it may make sense to allocate cash synthetically. The firm must disclose whether cash was allocated to the extracted performance and the effect of the allocation, or if no cash was allocated. For example, “Extracted performance presented includes allocated cash.  Cash and cash returns are allocated to extracted performance based on each carve-out’s size relative to its total portfolio, using beginning-of-month values.”

Hypothetical Performance

Hypothetical performance is performance results that were not achieved by any portfolio managed by the investment advisor and includes model, back-tested, and projected performance returns. It is prohibited from being distributed in mass mailings or on general advertising such as the firm’s website. It may not be included in an advertisement unless certain steps are taken to ensure it is not misleading.

First, the firm must have policies and procedures established to ensure the information presented is relevant to the investment objectives of the intended audience and only distributed to investors who have the resources and expertise to analyze the information.

Second, sufficient information on the criteria and assumptions of the performance must be included. This will differ depending on the type of hypothetical performance presented and should enable the intended audience to understand the criteria and assumptions used in calculating the hypothetical performance.

Third, the firm must provide (or offer to provide if a private fund investor) sufficient details about the risks and limitations of hypothetical performance. This requirement will be met by tailoring the disclosures to the intended audience, so they can sufficiently understand the risks and limitations.

If presented, hypothetical performance does not need to comply with the required time periods, related performance or extracted performance requirements. Hypothetical performance presented in response to an unsolicited investor request may be provided in a one-on-one communication and would not be subject to any of the above requirements. Additionally, performance provided to a private fund investor in a one-on-one communication is excluded from the scope of these additional hypothetical performance documentation and disclosure requirements.

If you would like to receive a copy of our template for calculating annualized and cumulative performance, or have any other questions regarding the marketing rule, contact us here.

Should SEC Regulations Re-Shape Your GIPS Reports?

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As firms update their annual GIPS Reports this year, unique questions in 2022 include whether to stick with the GIPS Standards requirements checklist or to incorporate new SEC Marketing Rule disclosures.

The SEC Marketing Rule specifically called out GIPS Reports as an example of a standardized presentation that, even if provided in a one-on-one meeting, would still meet the definition of an advertisement.  Why?  Because it is a presentation that is “[quote SEC marketing rule directly]”…typically created once a year and provided unchanged over and over again in many one-on-one presentations.  That said, new SEC statistics and disclosures do not have to be added to every page of a presentation, so firms need to consider the presentation in its entirety and ensure SEC disclosures are included in a fair and balanced manner.

That raises a lot more questions:

  • Should we add supplemental model net returns?
  • Should we continue to show only annual performance statistics, or update more frequently, to reflect any significant market changes since year-end?
  • Should we add the required five (5) and ten (10) year annualized performance to the GIPS Report, in addition to elsewhere? Should we create a table for additional performance statistics, or add as a single line item disclosure?

If your firm uses the GIPS Report as a standalone document, each question above must be considered.  Since the new SEC Marketing Rule requires that net returns are reflective of what a prospective client/investor would receive, the GIPS Report needs to reflect this on its own as well as including the five and ten-year annualized composite and benchmark performance.  The Rule also states that firms need to consider more frequent updates to their marketing materials to account for significant market changes over time.  This could mean updating the GIPS Report as frequently as quarterly to reflect those changes.

Most firms, however, include GIPS Reports as part of a larger, colorful firm/strategy pitch book as a primary means of distributing them to prospective clients and investors.  It is rare that a pitchbook doesn’t have separate performance pages, in addition to the GIPS Report, and the performance section often includes the most recent quarter-end performance, annualized performance, charts, and graphs for the strategy(ies) and benchmarks being presented.

Some firms even include a GIPS Report on the back of strategy fact sheet(s), to ensure they are providing GIPS Reports with performance even before there is any expressed interest in the strategy.  Those firms likely won’t re-shape their GIPS Reports with data and disclosures already on page one of the fact sheet not needing to be repeated in the GIPS Report on page two of the fact sheet.

Many legal experts emphasize that it is the presentation as a whole that needs to include the new required statistics and disclosures, not any individual page.  Important considerations, though, include the prominence of any required regulatory statistics not in the GIPS Reports, and also if material discrepancies exist.  Using the most conservative fee schedule in your GIPS Reports, and tailoring lower fees and better returns to individual prospects, is not a problem; showing better returns in your GIPS Reports than a prospective client could expect to achieve is likely to be considered misleading, though, even if lower returns relevant for the prospective client are included elsewhere in the pitchbook.  It’s also important to consider where the GIPS Reports are stored. Larger firms, with many client-facing professionals, may not know if a professional is using a GIPS Report as a stand-alone presentation.  If the GIPS Reports are in a folder easily accessed by sales and marketing professionals, it might make the most sense for your firm to ensure your GIPS Reports meet all of the GIPS standards and SEC requirements, just in case.

Whatever you choose, keep it simple and consult with your own attorney or SEC compliance consultant, as well.  The easier your policy is to maintain, the more likely you and your team will be able to consistently follow it.  We suggest you avoid maintaining two versions, if possible—a stand-alone version, and a fact sheet only version that doesn’t include statistics (already provided on page one).  It sounds good in writing – but multiple versions used by multiple people increases the likelihood of inputting and distribution missteps.  A single version, with a straight-forward policy is what we recommend, whether you add the SEC disclosures or make it very clear that GIPS Reports are never to be used outside of pitchbooks and factsheets that meet the requirements.

If you do decide to add the required disclosures to your GIPS Reports, check out our worksheet.

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 team.cascade@cascadecompliance.com.

SEC Portability Predecessor Performance

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Money Can’t Buy You Love – Or Your Manager’s Predecessor Performance

A portfolio manager’s track record is an important asset and key pillar of evaluation by institutional investors/asset owners.  Ensuring that a portfolio manager’s performance can—or whether it should—go with her/him/the team to a new firm is of critical concern for planning or evaluating any transition.

At a high level, the new or acquiring firm must:

  • Make sure the strategy stays intact, with no break in performance – ✓
  • Bring the entire team primarily responsible for investment decisions – ✓
  • Secure books and records to support substantially similar management and “not materially higher” performance – ✓
  • And now, with the SEC’s new marketing rule – make sure no one responsible for the predecessor performance ever retires, dies, or decides to do something different.

With portfolio managers leaving firms, and mergers and acquisitions happening frequently, the latest regulatory update on what predecessor performance can and can’t be advertised will impact the current published performance of any firms with acquired track records where key decision makers have since moved on.

Let’s say you are evaluating Firm B, which acquired a Team from Firm A with a great ten-year track record in 2018.  The Team was with Firm B for three years and advertises a 13-year track record through 2021, with a disclosure that the performance results prior to 2018 were achieved by the Team at another firm.  Then, the key portfolio manager moves on to Firm C (or buys a yacht and sets off to sail around the world).  A strict interpretation of the SEC’s new rule leaves Firm B with a three-year track record, and disclosure of the departure of a key portfolio manager in 2022.

– Whatever Firm B paid to acquire that great ten-year track record goes out the door with any key person responsible for achieving it –

What about Firm A?   Firm A can continue to show the performance of the Team from 2009 through 2018, linked to its ongoing performance, with disclosure of the departure of key personnel in 2018.

What about Firm C?  If only one member of a two-person team goes to Firm C, Firm C gets the portfolio manager, but not the predecessor performance.  If Firm C is acquiring a strategy managed by a single portfolio manager with the books and records to support the entire history, Firm C can advertise the previous performance for the full 13 years, but only as long as the portfolio manager stays at Firm C.

This strict interpretation of the SEC’s Marketing Rule, which goes into effect this November, dwarfs the nuanced differences between the SEC’s requirements and the Global Investment Performance Standards (GIPS®) portability requirements. But should the new rule be interpreted so narrowly?

Two next-level considerations that will impact predecessor performance decisions going forward:

  • Manager knowledge transfer
  • The transitive property (of equality) on books and records

Manager Knowledge Transfer:

The GIPS Standards take the position that performance belongs to the firm.  Once the Team left Firm A to join Firm B in 2018, if all the requirements were met to link the ten-year predecessor performance from Firm A, Firm B can advertise that performance. Period.

During the three years that the Team is part of Firm B, investment professionals may come and go, research analysts are trained and promoted to portfolio management, and after three years, the Team has left an imprint on Firm B, even if a key portfolio manager moves on in 2022.  According to the GIPS Standards, Firm B can continue to advertise the 13-year performance record.  CFA Institute staff has communicated in every presentation on this topic that they hope the SEC will consider manager knowledge transfer in its interpretation and enforcement of the latest predecessor performance requirements.

How long does knowledge transfer take?  Many solo portfolio managers move from one financial institution to another, without training a team, and in those cases, Firm B shouldn’t continue showing the performance of a manager no longer managing accounts there, no matter how much time has passed.  What if Firm B acquires the Team from Firm A, and after just a few weeks/months, the key portfolio manager leaves?  Can the rest of the Team remaining at Firm B carry the knowledge transfer forward?  Stay tuned – the industry is eagerly anticipating the SEC’s answers to these questions.

The Transitive Property (of Equality) on Books and Records:

We all learned in grade school that if a = b, and b = c, then it follows that a = c.

This is good news for new or acquiring firms that don’t claim compliance with the GIPS Standards: essentially, if all accounts are managed similarly, then a subset of composite performance should be substantially similar to the composite.  This is the heart of an ongoing nuanced difference between SEC requirements and the GIPS Standards: the SEC only requires books and records to support that the historical performance is for “substantially similar” managed accounts and that results are “not materially higher” than the performance of all accounts managed in that strategy.

If the Team’s strategy at Firm A was block traded, with substantially similar performance for 100 accounts, Firm B doesn’t need custodial statements or portfolio accounting records for all 100 accounts to advertise the Team’s performance from Firm A.  If 25 of the accounts follow the Team to Firm B, it’s likely Firm B could obtain statements for just those 25 accounts and support advertised predecessor results that are “not materially higher.”

If Firm B does claim GIPS compliance, the Team will need to bring books and records for all accounts to advertise and link performance from Firm A. If Firm A claimed compliance with the GIPS Standards, policies for input and calculation methodologies and composite maintenance are also important for the Team to bring to Firm B.

More predecessor performance questions before we get to the other side of November 2022?

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 team.cascade@cascadecompliance.com.