Tag Archive for: GIPS

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.

GIPS Compliance: Insights for Asset Owners

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Insights for GIPS Compliant Asset Owners – Getting comfortable with CFA Institute’s Net-of-Fee Terminology

During 2021, pension plan headlines included fee transparency, the improper treatment of cash flows (and its impact on performance), and the pros and cons of claiming compliance with the GIPS Standards for Asset Owners, to name a few. The number of public and private pension funds, endowments and foundations claiming compliance with the GIPS Standards is growing.  This article addresses key pros and cons and details net of fee reporting terminology for funds considering compliance with the GIPS Standards to consider.

The Pros:

Compliance with the GIPS Standards is largely an exercise in shoring up books and records, augmenting documentation of internal workflows, and gaining clarity on outsourced performance practices of third-party managers and consultants—all important exercises for fiduciaries.  It demonstrates a commitment to best practices, full and fair disclosure, and robust internal documentation that can lead to operational efficiency and enhanced internal controls.  It can also expose documentation gaps that can be corrected, if not historically, on a go-forward basis, with the ability to comply with the GIPS Standards once compliance can be supported for a 12-month performance history in the GIPS Total Fund Report, which contains pertinent disclosures that are comparable among funds globally.

The Cons:

As fiduciaries, funds must manage costs.  For asset owners already subject to GASB audits, complying with the GIPS Standards for Asset Owners will only build on required valuation and calculation methodologies already in place.  The GIPS Total Fund Report can be seen as an extra layer of voluntary reporting.

Having worked with audited firms and funds for over 25 years, Cascade has seen first-hand that more than an extra layer, the process of getting into GIPS compliance connects an organization’s people to the performance results in a way that undergoing an audit does not.   A fund audit is focused on the data, while the GIPS Standards focuses on the organization.  Interviews with compliant funds continue to find the focus on policy documentation the most helpful part of the GIPS compliant process.  Improved recordkeeping and collaboration inside of and between departments reinforces ongoing operational improvements.

Total Fund Net-of-Fee Terminology

Below is a summary of the GIPS Standards net-of-fee terminology, what must be included in a total fund net-of-fee return, and the different types of additional returns that can be included in a GIPS Total Fund Report.

The GIPS Standards for Asset Owners (provision 22.A.24) require that a total fund net of fee return be calculated net of transaction costs, all fees and expenses for externally managed pooled funds, investment management fees for externally managed segregated accounts, and investment management costs.  Below is a breakdown of what is included in each of the above fees and what is not included.

1. Transaction Costs

CFA Institute limits transaction costs to the cost of buying and selling investments.

2. All fees and expenses for externally managed pooled funds and investment management fees for externally managed segregated accounts

If asset owners can use net asset values from externally managed pooled funds when they value them within the larger total fund, and the net asset value includes the management fee, then no additional work is required.  However, if there are other investment management fees being paid for the management of the external pooled fund from another account, such as a fund-of-fund management fee, these expenses must also be included.  Carried interest also falls under investment management fees and must be included.  Similarly, for segregated accounts, investment management fees must include any performance-based fees or manager of manager fees, in addition to asset-based fees.

3. Investment management costs

The GIPS Standards for Asset Owners define investment management costs as “all internal costs for both internally and externally managed assets.” This ensures the oversight board has a look through for all the fees associated with operating the pension fund, endowment, or foundation.  Capturing a fund’s internal investment costs, as well as external management fees and transaction costs, is not new to funds regularly undergoing GASB audits.  GIPS compliance does typically result in more robust documentation and disclosure of what is and isn’t included in a total fund’s annual net-of-fee performance, including additional clarity on the net-of-fee performance-related data from external managers.  Fees an Asset Owner will want to consider when determining internal investment management costs:

Asset Owners must present performance net of all fees; however, the total fund performance may also include different types of returns in addition to the total fund net-of-fee return.  In a GIPS Total Fund Report, four other types of returns can be presented, with additional disclosure:

Cascade Compliance has decades of experience working with the GIPS standards, and its employees have worked with firms and asset owners.  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.

Verifier Independence

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Verifier Independence drew dozens of attendee inquiries and comments at the 25th Annual GIPS Standards conference this year.  The growth of virtual service offerings during the pandemic, more automation, and M&A activity in the compliance and verification provider space all require a fresh look at verifier independence.

Overview

The 2020 GIPS Standards, for both Firms and Asset Owners, added to the Fundamental requirements that recipients of a verification must gain an understanding of the verifier’s policies for maintaining independence and consider the verifier’s assessments of independence. What does this mean?

Verifiers are required to conduct their work independent of their clients in an unbiased manner, because the verification opinion is relied on by potential investors and other market participants and stakeholders.  Verifiers cannot examine their own work, function in decision making roles, serve in an advocacy role or have mutual or conflicting roles with clients, and the GIPS Standards require verifiers to document their policies on independence at both the firm and employee level. Requesting and reviewing your verifier’s policies on independence is a way to determine if any potential independence issues exist.

Determining Independence

To determine if an independence issue exists, firms/asset owners should consider other services provided by the verifier. If the verifier does not offer any other services or you do not and will not engage in other services, then you need to consider if the verifier is involved in compliance decisions to the extent they are verifying their own work.

Many verifiers provide pre-verification consulting services where they provide templates and consult with verification clients on how to document policies or comply with the GIPS Standards.  Verifiers can provide useful insight on considerations for the creation of meaningful composites and education on industry practices for including GIPS Reports with prospective client communications. In these cases, whether or not verifier independence issues exist would depend on the verifier’s level of involvement.

Frequently Asked Verifier Independence Questions, 2021 GIPS Standards Conference

  1. What does testing their own work mean?

A verifier would be testing their own work if, for example, they compile your account data in a composite calculation spreadsheet or create your firm’s GIPS standards policy manual, and then verify your firm. Any documents that the verifier directly creates on behalf of the firm would fall into this category of testing their own work if the same verifier was engaged for verification services. However, if your verifier provides templates that your firm populates and the verifier reviews, this is not considered testing their own work.

  1. Most, if not all, verifiers provide spreadsheets to their clients if they need a tool to calculate composite performance. They then turn around and verify that calculation. Isn’t this “testing their own work”?

CFA Institute provides examples of services that are unlikely to create an independence issue. These examples include, formulas and calculation examples, example policy language and GIPS compliance checklists. If the verifier provides a tool that your firm uses to calculate performance but does not actually input the values on behalf of the firm, there is likely no independence issue.  See more examples of services a verifier can provide without violating independence here.

  1. We hired a consultant to start our GIPS compliance program. They wrote our P&Ps, drafted our GIPS Reports, and created/maintain our composites based off initial & ongoing feedback from our SMEs. This was signed off on by the CCO. Can they now Verify us since we made the mgt decisions? Is there an independence issue, and if so, how much time must pass before the verifier is considered independent?

This situation would be considered a violation of verifier independence if the same consultant was used to verify the firm. The consultant would be testing their own work based on the information provided above.  See more examples of situations where other services lead to an independence issue here.

There is no set amount of time that must pass before the verifier is considered independent again. This was answered during the 2021 GIPS Conference and the panelists agreed that if an independence issue such as this exists, it will exist indefinitely. This is because the consultant set up the firm’s policy manual and created the firm’s composites.  The firm should consider other verification firms if pursuing verification.

  1. Our verifier has a division that offers composite software. It is a completely different business line from the verification business. If our firm utilized their composite software, can the verifier still be considered independent?

This was also answered at the 2021 GIPS Conference, and the panelists agreed that if the verifier has another division that offers composite software, there would be an independence issue if the firm chose to use the verification division for GIPS verification.  When firms are considering hiring a verification firm, they should be considering the options that are above reproach.  If there is doubt about whether the verifier is independent due to engaging other services, then it might be best to look to another provider. 

At Cascade, we provide our policies on independence to each client upon signing a contract and provide an updated copy annually.

Access our Verifier Independence Checklist

Cascade Compliance’s checklist is a starting point when considering the independence of a verification firm.  We also recommend reviewing the Guidance Statement in its entirety.

Navigating Actual vs. Model Net-of-Fee Performance

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One of the more common questions we get asked by firms is whether they should use model or actual fees to calculate net-of-fee composite returns.  With the soon-to-be-implemented SEC Marketing Rule requirements for net-of-fee composite performance calculations, many firms will need to reconsider their current calculation methodology to make the best decision going forward.

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