We occasionally ask folks what they think is the most confusing aspect of the GIPS(R) (Global Investment Performance Standards), which typically results in a variety of responses. To me, the most confusing term is “discretionary account.” Recall that compliant firms must place all actual, fee-paying, discretionary accounts into at least one composite. But most firms read “discretionary” and immediately take this to mean legal discretion; that is, does the firm have the authority to trade on behalf of the client.

But this isn’t what the term means…it’s dealing with discretion from a GIPS perspective. That is, has the client placed any restriction or requirement on the manager such that the result will not represent the manager’s style? If “yes,” then it’s non-discretionary.

I was at a new client last week and they were putting every account into composites, even though they clearly had some flexibility at hand. For example, they had a new client which imposed a restriction which would have caused roughly 10% of their model’s typical holdings to be excluded from this client account, which would have resulted in returns which wouldn’t represent the composite. They were planning to create a whole new composite just for this account. And while they aren’t prohibited from doing this, why do it if you can simply flag the account “non-discretionary”?

Discretion is a great tool that’s available to all GIPS-compliant firms, but it must be used in a proper manner. Their rules for discretion must be documented in writing. And general rules such as “an account is deemed non-discretionary if the CIO (chief investment officer) feels the account has restrictions that impedes his ability to invest” don’t work: we need clear cut rules; rules that can be tested by an independent party.

If you’d like to share what you think is confusing about the standards, feel free!