Tag Archive for: GIPS

Selecting a Verifier

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Three Crucial Considerations When Selecting a Verification Firm: People, Process, and Fees

Every year, around this time, budget reviews for the upcoming year often prompt firms to review long-term service providers. While firms meticulously scrutinize their budgets, verification providers are also assessing fees for the following year to determine if an increase is justifiable. If you haven’t yet evaluated your current verifier, the CFA Institute’s verification questionnaire offers valuable questions for your consideration. In addition to the CFA Institute’s questionnaire, this article provides supplementary insights that may prove beneficial as you evaluate your existing verification firm or search for a new one.

People

People constitute the most pivotal component of any verification process. The firm you engage and the individuals they enlist for your verification must possess experience, knowledge, and a strong commitment to the task. Furthermore, it’s essential to consider how a verification firm plans for the future. Over the past decade, we’ve observed several mergers and acquisitions among verification and compliance firms. Strangely, one of the most important questions, not included in the CFA Institute’s questionnaire, is related to succession planning: “What is the succession plan for the firm?” As the owners of verification firms approach retirement, this question is often overlooked, leading to inadequate succession planning or the sale of firms to competitors.

Another vital question to ask is, “What caliber of staff will be working on the engagement?” Verification firms typically assign one senior-level person and one junior-level person to their engagements. Sometimes, the junior-level team member may have less than a year of verification experience and ends up doing most of the work. Understanding your engagement team is crucial for a successful and efficient verification process. [Do we want to add a sentence here, similar to the Fees section, that addresses Cascade’s difference? “At Cascade, partners are involved in the regular communications/emails/phone calls before during and after the verification, and even our junior-level staff working with clients have more than 5 years of GIPS compliance verification experience.”]

Process

It’s imperative to inquire “Does the verification firm consider regulatory requirements beyond the GIPS Standards when reviewing your marketing materials.” With the SEC Marketing Rule now in full effect, this question holds greater importance than ever. Some verification firms choose not to comment on any aspect of the SEC Marketing Rule. However, we believe this approach is misguided. Verification firms often position themselves as performance experts, making the SEC Marketing Rule an important part of any RIA’s GIPS compliance process. As a client, you shouldn’t hesitate to seek their insights on the performance aspects of the SEC Marketing Rule.

An additional aspect to evaluate is “How frequently does the verification firm communicate before, during, and after the verification process?” Effective communication during the verification process significantly impacts its timeliness. Questions to consider include whether you will have timely email follow-ups and regularly scheduled weekly, bi-weekly, or monthly calls during the verification, and how the verification firm stays informed and keeps your firm informed about industry-specific regulatory changes.  At Cascade, clients receive timely call summaries for every regularly scheduled call that keep your entire team informed on key issues and next steps, and your entire verification team—including partners—participates in those calls and call summary communications. Frequent communication from your verifier ensures that your firm receives the information it needs for a successful compliance program.

Fees

With the SEC Marketing Rule considerations impacting GIPS Reports this past year, it’s important to know what guidance is or isn’t included in your verification fees:  “Do verification fees encompass consulting regarding the performance aspects of the SEC Marketing Rule?” This question could be a determining factor in your decision to hire a specific firm. Some verification firms charge additional fees for consulting on performance requirements of the SEC Marketing Rule, while others include this service as an integral part of their offerings. Recognizing that investment management firms often have external compliance providers to assist with regulatory disclosures and documentation, verification firms have the expertise to provide valuable insights on the performance aspects of the rule.

Firms could do well to ask about fee increases: “Does the verification firm enforce automatic fee increases and how are increases communicated to their clients?” Some firms have implemented substantial fee hikes without adequate client communication. At Cascade Compliance, we take a different approach: when you become a client, we freeze your fees for the initial two years and guarantee a fee increase cap moving forward. As a 100% employee-owned company, we have the autonomy to control pricing and manage costs and competitive staff retention packages, offering our clients the peace of mind of working with the decision-makers.

In conclusion, selecting a verification firm is a critical decision that should be made after careful consideration of people, processes, and fees. By asking the right questions and evaluating these three key components, you can make an informed choice that aligns with your firm’s needs and expectations. Remember, choosing the right verification partner can have a substantial impact on your organization’s success and compliance program.

Cascade Compliance has over 45 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.

Hypothetical Performance Risk Alerts

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As long as you haven’t been living under a rock for the past year, you may have heard that a modernized Securities and Exchange Commission (SEC) Marketing Rule went into effect this past November 2022. These past few weeks, the SEC has charged 10 firms with violating the New Marketing Rule (NMR), and each of the firms charged share a common error: advertising hypothetical performance without establishing and implementing the required internal “policies and procedures reasonably designed to ensure that the performance is relevant to the likely financial situation and investment objectives of the intended audience.”

In this article, we explore the importance of internal policies and procedures—especially as it pertains to hypothetical performance under the NMR.  The adopting release for the NMR notes that hypothetical performance can be useful, and it isn’t banned.  However, firms not only need to document how they are managing the risk of showing returns with “attention-grabbing power”[1] and ensuring those returns are relevant, they also need to be following those internal procedures.

Policies and procedures—and the compliance officers charged with drafting them—may finally be getting the attention they deserve.  All firms claiming compliance with the GIPS standards have comprehensive written policies covering distribution of performance and disclosures, and the vast majority of those firms also have an outside verifier to test that the policies are actually implemented.  One of the key benefits of claiming compliance with these voluntary standards, that goes way beyond marketing objectives, is attributed to those policies and procedures: getting input into the policies across the firm; having relevant training and continuous feedback from independent verifiers; and providing accessibility and consistent application to newcomers across the firm and over time.

Whether firms are claiming compliance with the GIPS standards or not, well-written performance calculation and distribution policies tailored to your firm with input from all departments to ensure relevance and increase firmwide adoption/implementation is an opportunity to raise operational efficiencies, not a cost center.  The inclusion of detailed actual and hypothetical performance requirements in the NMR has created an opportunity for firmwide dialogue in order for your firm to adopt updated regulatory compliance policies that reflect the NMR requirements that aim to ensure performance is relevant.

The NMR emphasized that hypothetical performance is not suitable for broad marketing to a mass audience, and the nine firms charged in September 2023 all included hypothetical performance on their public websites.  At first read, it doesn’t appear these firms took the time for that firmwide dialogue or careful consideration.  If hypothetical performance is an important tool for your firm and relevant to many of your prospective clients, then the appropriate response to these charges isn’t to quit showing hypothetical performance altogether, but to carefully consider the context in which you present such performance figures. With mass audiences, firms can’t make assumptions about individual financial situations or investment objectives or know if the recipients of the performance are sophisticated enough to interpret the information and understand the risks.  Even in one-on-one presentations, it’s important to make sure your firm is documenting and tracking who is receiving hypothetical performance and relevance criteria.  Our recommendation is to not show hypothetical performance on your website to reduce your regulatory risk.

Compliance with these new requirements is paramount, not only to avoid the very real censure, penalties, and other regulatory consequences faced by these firms, but also to uphold transparency and trust within the industry. Investment firms that successfully navigate these changes will be better positioned to provide investors with meaningful and relevant performance information for their financial decisions.

As firms continue to evaluate value-add performance consulting and verification providers, we hope you’ll consider Cascade Compliance.  We can tailor our high-touch personalized professional service, experienced staff, and competitive fees for a best-fit solution for your firm.  For firms already working with another verifier, we will make the transition seamless, so you only notice the extra responsiveness and attention to detail. Cascade Compliance has over 45 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.

[1] SEC.gov | SEC Sweep into Marketing Rule Violations Results in Charges Against Nine Investment Advisers

From Team Performance to Investment Returns: Ted Lasso and GIPS Standards

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What do the GIPS Standards and Ted Lasso have in common?

The third season of Ted Lasso began in March 2023. For those that have not seen the show, it is about a small-time college football coach from Kansas named Ted Lasso, who is unexpectedly hired to coach a struggling English Premier League soccer team, AFC Richmond, despite knowing very little about soccer. While it may seem that Ted Lasso and the Global Investment Performance Standards (GIPS®) have nothing in common, we invite anyone working with GIPS compliance to explore the important similarities below and feel as good about what they bring to work as what Ted brings to his coaching.

At its core, Ted Lasso is about ethics, transparency, teamwork, and continuous improvement, and we are using the GIPS Standards framework to help clients tackle similar challenges every day.

Ethics: Ted and the GIPS Standards focus on ethics. Ted Lasso is known for his strong moral compass and commitment to doing what is right. Similarly, the GIPS Standards require investment managers to adhere to a strict code of ethics when reporting performance data, ensuring that they are not misrepresenting their results or misleading their clients. Choosing to be ethical is more than just following the rules; it’s the foundation for all of the decisions that come after.

Transparency: In the show, Ted is known for his open and honest communication style, an understated superpower that helps to build trust and rapport with his team. The GIPS Standards provide a powerful framework for investment managers to provide transparent and accurate performance data to their clients to build trust and confidence in their investment strategies.

Teamwork: Of course, a soccer show is about teamwork, but so is GIPS compliance. It applies to the whole firm, not just the back office or the front office, and the best GIPS compliance teams have representatives from executive leadership, compliance, operations, technology, marketing, and portfolio management.

Continuous Improvement: Ted is constantly looking for ways to improve himself and his team, even when things are going well, just as the GIPS Standards require investment managers to regularly review their performance reporting processes and make changes as needed to ensure they are meeting the highest standards of accuracy and transparency.

And the list goes on….

Attention to Detail: Both Ted Lasso and the GIPS Standards place a high value on attention to detail. Ted is known for his meticulous planning and attention to small details that can have a big impact on the success of his team. Anyone that’s worked with the GIPS standards knows compliance requires fiduciaries to pay close attention to the details, quarter after quarter, to ensure accuracy and consistency.

Standards of Excellence: Finally, both Ted Lasso and the GIPS Standards are focused on achieving high standards of excellence. In the show, Ted Lasso sets high expectations for himself and his team and is always striving to improve and achieve their goals. When the GIPS Standards were created, they were designed to provide the investment management industry a pathway to achieve the highest standards of accuracy, transparency, and ethical behavior for investment performance reporting, for firms (and now asset owners) to build credibility and trust with their clients and constituents.

While the connections between Ted Lasso and the GIPS Standards may seem tenuous at first, both share a commitment to excellence, ethics, transparency, teamwork, and continuous improvement. They also emphasize the importance of thinking long-term, paying attention to detail, and building trust through open and honest communication. Additionally, both have a strong focus on teamwork and collaboration, whether that’s between the characters in the show or between investment managers and their clients. Ultimately, these shared values and principles can help individuals and organizations achieve success in their respective domains, whether it’s on the soccer field or in the investment management industry.

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.

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.