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IFT Notes for Level I CFA® Program

R04 Introduction to the Global Investment Performance Standards (GIPS)

Part 1


 

Introduction

This reading focuses on:

  • Why the GIPS standards were created and whom do they apply to?
  • What are composites and what is their purpose in performance reporting?
  • Who can claim compliance with GIPS, and is there a verification process?

Note: most of the material presented here is taken from the curriculum.

1. Why Were the GIPS Standards Created?

GIPS standards were created to make it easier to compare different investment management firms. Without a standard, different firms would select the method which would make their performance look better.

The GIPS standards are a practitioner-driven set of ethical principles that establish a standardized, industry-wide approach for investment firms to follow in calculating and presenting their historical investment results to prospective clients. The GIPS standards ensure fair representation and full disclosure of investment performance. In other words, the GIPS standards lead investment management firms to avoid misrepresentations of performance and to communicate all relevant information that prospective clients should know in order to evaluate past results.

Misleading practices in the absence of GIPS included:

  • Representative accounts: Showcasing only the top-performing portfolio to represent the firm’s overall investment results.
  • Survivorship bias: Excluding poorly performing portfolios and presenting an average performance history.
  • Varying time periods: Presenting performance for a selected time-period during which the mandate produced excellent returns.

2. Who Can Claim Compliance?

Any investment management firm can claim compliance. Complying with the GIPS standards is voluntary. Only investment management firms that actually manage assets can claim compliance. Plan sponsors and consultants cannot claim compliance unless they manage assets for which they claim compliance.

Compliance is a firm-wide process that cannot be achieved on a single product or composite. A firm has only two options with regard to compliance with the GIPS standards:

  • Fully comply with all requirements of the GIPS standards and claim compliance through the use of the GIPS Compliance Statement; or
  • Not comply with all requirements of the GIPS standards and not claim compliance with, or make any reference to, the GIPS standards.

3. Who Benefits from Compliance?

Two groups benefit from GIPS compliance: investment management firms and prospective clients.

Following the GIPS standards allows investment management firms to assure prospective clients that the historical track record they report is both complete and fairly presented. Compliance enables the GIPS-compliant firm to participate in competitive bids against other compliant firms throughout the world. Achieving and maintaining compliance may also strengthen the firm’s internal controls over performance-related processes and procedures.

Investors have a greater level of confidence in the integrity of performance presentations of a GIPS-compliant firm. Investors can easily compare performance presentations from different investment management firms.

Compliance with the GIPS standards does not eliminate the need for due-diligence, but it enhances the credibility of investment management firms that have chosen to undertake this responsibility.

4. Composites

One of the key requirements of the GIPS standards is the use of composites. A composite is an aggregation of one or more portfolios managed according to a similar investment mandate, objective, or strategy. Assume a firm manages portfolios based on one of the following strategies:

  • Strategy A: Aggressive growth. Under this strategy the firm selects small-cap stocks with strong growth potential over the next few years.
  • Strategy B. Large cap value. Under this strategy large-cap value stocks are selected.

Give this scenario the firm should create a composite for Strategy A, and another composite for Strategy B.

A composite must include all actual, fee-paying, discretionary portfolios managed in accordance with the same investment mandate, objective, or strategy. By “actual” we mean these should be real and not dummy/model portfolios to simulate the returns. Portfolios for which the client does not pay a fee must not be included. For instance, there may be charitable organizations that do not pay a fee for their assets being managed. These should not be included. By “discretionary”, we mean the investment management firm has the right to determine and purchase suitable securities for a portfolio. If there is a portfolio where the client determines what securities should be purchased, then it is non-discretionary.

The determination of which portfolios to include in the composite should be done according to pre-established criteria (i.e. on an ex-ante basis), not after the fact. This prevents a firm from including only the best-performing portfolios. This is important because performance numbers are reported based on composites.

5. Verification

Firms that claim compliance with the GIPS standards are responsible for their claim of compliance and maintaining that compliance. Once a firm claims compliance with GIPS, they may voluntarily hire an independent third-party to perform verification. Just as GIPS compliance is voluntary, verification is also voluntary. Verification is performed with respect to an entire firm. It is not done on composites, or individual departments.

Verification must be performed by an independent third party. A firm cannot perform its own verification. Third-party verification brings additional credibility to a firm’s claim of compliance. To understand why a firm would pay to be verified if it is voluntary, assume there are two firms, A and B. Firm A claims GIPS compliance and firm B claims GIPS compliance with third-party verification from a reputed firm. As an investor, which firm would you be more comfortable with? Obviously firm B, and that gives firm B an advantage over firm A.

Verification tests include:

  • Whether the investment firm has complied with all the composite construction requirements of the GIPS standards on a firm-wide basis, and
  • Whether the firm’s policies and procedures are designed to calculate and present performance in compliance with the GIPS standards.

6. The Structure of the GIPS Standards

The provisions within the 2010 edition of the GIPS standards are divided into nine sections:

  1. Fundamentals of Compliance
  2. Input Data
  3. Calculation Methodology
  4. Composite Construction
  5. Disclosure
  6. Presentation and Reporting
  7. Real Estate
  8. Private Equity
  9. Wrap Fee. Separately Managed Account (SMA) Portfolios


Ethics Introduction to GIPS Part 1