I conducted a GIPS(R) (Global Investment Performance Standards) verification for a new client earlier this year, who had previously used a different verifier. During the course of the review, I discovered a number of items that prohibited me from issuing a “verification report,” including their policy on switching accounts from one composite to another, when a client’s objectives had changed. They would keep the account in the old composite throughout the transition period, and move it out at month-end, when it had fully transitioned, and on that same date move it into the new composite. I explained that once they began the transition, they had to remove the account from the old composite. They requested a more formal justification for the basis for my position, and I will deliver it to them shortly. But I thought it worth discussing here, as well, as this may be a problem others are dealing with.

The client provided me with an example which shows the account’s transition:

In this example we can see that on or about the 20th the shift from the old strategy to the new began.

This matter goes to the whole subject of composite definition and makeup. A composite consists of accounts with similar investment styles, strategies, etc. The members of the composite take on the identity of the composite’s definition, thus qualifying their presence within the composite. The moment you take an account and begin to transition its identity to that of another composite is the moment the account begins to no longer look like the composite from where it came (i.e., to lose the earlier identity). The transactions the firm is making to alter the account’s identity are ones that they would otherwise not be making; the identity of the account would have remained intact, had the client not requested a change in style. But in honoring this request, they are altering the account’s identity such that during the transition period, it is losing the identity of the original composite and taking on the identity of the new one, so that when they are complete it now fits into the new composite.

And yet they still have that account, along with the sales that occurred, in the original composite, even though it lost that account’s identity; consequently, its return uses transactions and an ending market value that don’t belong. On the final day it doesn’t resemble the other accounts in the original composite; it doesn’t have the identity of the composite and clearly doesn’t belong. Consequently, this account does not belong in the original composite on the end date nor during the transitional period.

Just as with a new account, you don’t bring it into the composite while you’re transforming it from its original state to the composite identity, you don’t move the transitioning account in until it has taken on the identity of the composite it is moving to (as you correctly do). And, just as with an account that is terminating, where you don’t keep it in the composite while you are liquidating its assets to meet the client’s request, taking actions you wouldn’t otherwise do, and keeping the account in the composite, the account that is losing the identity of the original composite cannot stay in that composite while you are transforming it to the new identity

On page 101 of the 2006 edition of the GIPS Handbook we find “Firms are not permitted to include portfolios with different investment strategies or objectives in the same composite.” At the end of the month the account has transitioned to the new composite’s strategy, and yet is still in the old composite. This is a violation of this prohibition.

There’s also a Q&A which addresses this topic:

One of the portfolios in our All Cap Growth Equity composite changed objectives towards the end of the second quarter (client agreement date: June 21) from All cap ($300MM and above market cap) to Mid Cap ($1B – 10B).

Should the portfolio be taken out of the All Cap composite for June, even though the portfolio’s objective only changed in the last 9 days of the month? In talking to the portfolio managers involved, no changes were implemented during the short period because of the similarity of the two styles (all cap vs. mid cap)

Does the client objective change automatically exclude the account from being in the all cap composite for June?

Shifts from one composite to another should be consistent with the guidelines set forth by the specific account agreement or with documented guidelines of the firm’s client. In the situation you present, if there was any latitude within the agreement as to when the change should occur, in the interest of fair representation and full disclosure, the firm should include the account in the All Cap Growth Equity composite only through the last full measurement period that the account was managed to that strategy.

Do the standards explicitly address the issue of timing when it comes to composite switching? No. However, there is clearly enough supporting material to justify the requirement that once an account begins to transition from one strategy to another, it needs to be pulled.

You might ask, “well, I thought that all actual, fee-paying, discretionary accounts have to be in at least one composite; if we remove the account during the transition period we’re violating this rule.” You’re correct about the rule, but there are exceptions and this is one of them.