(Note: I wrote this post as a guest blogger for the STP Investment Services blog, but it appears that blog is offline and we received a request for the information, so I decided to post the information directly here.)
The What, Why and Who of the GIPS Standards
In this blog post, I give you some quick and simple answers to the “what,” “why” and “who” questions that many people ask with respect to the GIPS Standards.
What are the GIPS Standards?
The GIPS Standards are voluntaryglobal standards for the presentation of investment performance results to prospective clients. That the standards are “voluntary” and deal with presentation to “prospective clients” are two of the most important aspects of the GIPS Standards.
By voluntary, we mean that investment firms may choose to comply with the GIPS Standards – or they may choose not to. There is no governing body that forces firms to comply with GIPS. Different countries may have various laws that govern the presentation of performance results, separate from the GIPS Standards. In fact, the GIPS Standards require compliant firms to follow the law in situations where the law differs from the GIPS Standards (in such a situation firms must disclose in their presentations the manner in which the regulations differ from the GIPS Standards). It should be noted that locally, regulators may cite firms that have a false claim of compliance with the GIPS Standards. Otherwise, with compliance being voluntary, the GIPS Standards represent a form of self-regulation that the investment industry has adopted on a global basis.
It is also important to consider what the standards are not. The standards are not calculation standards or reporting standards. When we say that the standards are not calculation standards, we mean that they are not an “A-to-Z” reference manual as to how the calculation of performance must be done. Yes, it is true that there are certain basic requirements for the calculation of performance that must be met (covered in other chapters in this guide). At the same time, it is up to the firm claiming compliance with GIPS to determine (and document) its policies and procedures for establishing and maintaining compliance with GIPS – including the calculation of returns, dispersion and other performance data. As long as the requirements of GIPS are met, firms have a lot of leeway in defining how they perform the calculations. One of the most important aspects of the GIPS Standards is that firms define (and document) their policies as clearly and objectively as possible, and that they apply their policies consistently. This supports two main objectives of the GIPS Standards – fair representation and full disclosure.
When we say that the GIPS Standards are not reporting standards, we mean that the standards do not dictate the format of the firm’s compliant presentation. The standards do prescribe requirements and recommendations for the content (i.e., the presentation elements) that must go into the composite presentation, and the accompanying disclosures. It is up to the firm to format this information. So again, the firm has a lot of flexibility in creating compliant composite presentations. Again, the ideals of fair representation and full disclosure should be met.
What items must a firm show in a composite presentation?
This list is not exhaustive, but a quick summary of what compliant firms must show includes:
- Generally, time-weighted returns (TWR) that separate client contribution from manager results. For closed end real estate and private equity funds, since inception internal rate of return is shown.
- Annual composite returns (a composite is the aggregation of accounts managed to the strategy).
- A measure of the internal dispersion (i.e., range) of returns of portfolios within the composite.
- As a measure of risk, the variability (standard deviation)of the composite’s historical returns.
- The amount of assets in the composite each year and the number of portfolios in the composite
- The amount of firm assets each year.
- Disclosures about the firm and the given composite designed to help the reader of the presentation understand the firm, the composite, and the performance history being shown.
The GIPS Standards promote the comparability of manager performance across firms and across borders. By requiring firms to show the same information, the prospect is better equipped to compare managers and make an informed decision as to which manager it should hire.
Why are there standards for performance presentation to prospective clients?
The GIPS Standards are a direct “descendent” of other predecessor standards that were created in various local areas dealing with presentation of performance results to prospective clients. The GIPS Standards, introduced in 1999, are global standards that incorporate the best practices from the participating local country sponsors.
In the late 1970s and early 1980s, there were several abuses that were becoming commonplace as far as how firms presented their performance to prospective clients. Some of the typical problems were:
- Presentations that only showed the firm’s best performing accounts
- Returns calculated based on unsubstantiated pricing
- Annualization of partial annual periods
- Reporting/presentation of best performing periods, omitting poor performing periods
- Comparisons of performance with either low-return, or inappropriate benchmarks
- Calculations that did not segregate manager returns from the client contribution
- Presentations created by marketing departments that underplayed unfavorable data and highlighted persuasive elements
Because of these problems, prospective clients had difficulty making informed, sound decisions regarding what investment manager they should hire.
Key events in the history of performance standards development:
- 1966: Peter Dietz’s seminal work, “Pension Funds: Measuring Investment Performance,” was published, introducing what came to be known as the time-weighted return.
- Late 1960s: the Bank Administration Institute published return calculation guidelines based on Dietz’s work.
- 1987: Financial Analysts Federation created the Committee for Performance Presentation Standards (CPPS). Key recommendations from their report:
- The use of time-weighted return was recommended.
- Presentation of performance gross-of-fees was recommended.
- The report recommended the inclusion of cash in portfolio returns.
- Construction and presentation of asset-weighted composites was recommended.
- 1990: The Association for Investment Management and Research (AIMR) board of governors endorse the AIMR-PPS.
- 1993: The AIMR-PPS is published.
- 1997: 2nd edition of AIMR-PPS published
- 1999: The first edition of the GIPS Standards was published.
- 2005: The second edition of the GIPS Standards was published.
- 2010: The third and current edition of the GIPS Standards was published, going into effect on January 1, 2011.
- 2012: Guidance Statement on Alternative Investment Strategies and Structures issued
- 2013: Exposure draft for the Guidance Statement on the Application of the GIPS Standards to Pension Funds, Endowments, Foundations and Other Similar Entities reeased
To whom do the GIPS Standards apply?
The GIPS Standards are voluntary standards that may be adopted and complied with by any investment firm with discretion over assets. This includes all of the traditional asset classes (cash, equities, fixed income) and alternative asset classes (commodities, private equity, real estate, hedge funds). The GIPS Executive Committee has recently introduced a document clarifying thatpension funds, and other managers of managers, can claim compliance with the GIPS Standards. While the GIPS Standards are commonly followed by managers seeking institutional clients, there are also a large number of retail investment managers that claim compliance with GIPS.
How does compliance with GIPS benefit managers, beyond being hired?
Compliance with GIPS can benefit investment firms in many ways, including:
- providing track record transparency and the ability to have a full/fair review of performance results for internal purposes
- creating a framework within which the manager’s firm can document the decisions made and the justification behind them when a new scenario occurs in the performance processing and/or investment operations of the firm
- allowing a better process for ensuring the marketing literature reflects the underlying information
- promoting an improved reputation due to the recognition of GIPS compliance
How does the existence of GIPS benefit investors?
Some of the benefits of GIPS for investors include:
· An enhanced ability to compare the performance of strategies among managers
· The improved likelihood that investors can understand the information in managers’ presentations and the data behind it; thus, they are able to ask relevant questions to enhance their understanding of the strategy
What is Verification and How Does It Add Value for Investment Firms?
Verification is the use of an independent third party to test an investment firm’s claim of compliance with the GIPS Standards. Verification tests two things, specifically. First, it tests whether the firm has complied with all of the composite construction requirements of GIPS on a firm-wide basis. Secondly, it tests whether the firm’s policies and procedures are designed to calculate and present performance in compliance with the GIPS Standards. Firms that claim compliance with GIPS are not required to be verified, but for investment managers seeking institutional business, it has become a de facto requirement. Most institutional investors will inquire as to whether managers they are considering a) claim compliance with GIPS, and, b) have been verified by an independent third party. Managers are often eliminated from consideration if they have to answer no to these questions. Thus, establishing and maintaining compliance with GIPS, accompanied by verification by an independent third party are essential to investment managers seeking to grow their business.
I hope this post helps give you an introduction to the GIPS Standards and the concepts of compliance and verification. If you have any questions on these topics, please feel free to contact me at jsimpson@tsgperformance.com.