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* Actually, the move occurred last Autumn, and some more recent posts have been made there.  Many of the historical posts have been transferred to the new location - I will gradually add the remaining posts.

A Little Piece on GIPS... (repost)

 

(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 voluntary global 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:

1. The use of time-weighted return was recommended.
2. Presentation of performance gross-of-fees was recommended.
3. The report recommended the inclusion of cash in portfolio returns.
4. 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 that pension 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@spauldinggrp.com. 

Performance with Leverage, Part I

Leverage can be a confusing topic, so I figured it is worth covering in a few blog posts.  In this first post, we'll deal with return calculations for portfolios that employ leverage.

Leverage is the use of borrowing, typically with an intent to amplify investment gains (and thus, returns).  The use of leverage is also sometimes referred to as margin borrowing.

When a portfolio uses leverage, we can refer to two different returns:

• the leveraged return is the actual return based on the portfolio's total invested capital
• the cash return is the unleveraged return; i.e., the return on the underlying assets, ignoring the use of leverage

 For example, let's say an investor has 400 million euro to invest but wants to invest in a 500 million euro real estate property.  If the investor limits herself to her cash at hand, she can't puchase the property.  But, if she uses leverage (i.e., borrows 100 million euro) she can acquire the property.  The investor will have to pay a cost of borrowing (we will assume that is 5% interest per year).  In this scenario:

•  the cash return is the return on the 500 million euro property she acquires
• the levered return is the return on her entire portfolio; i.e., her 500 million euro property and her -100 million cash borrowed

Assume over the investment period of one year, the property has appreciated to 540 million euro.  We can calculate the cash basis return as follows:

Note that this cash basis return is the same return that the investor would have if she was somehow able to purchase 400 million worth of the 500 million euro property.

The levered return, however, is higher:

The investor has successfully amplified returns.  The levered return of 8.75% is higher than the 8% cash basis return.  This is true because the return on the underlying asset (i.e., 8%) is higher than the cost of borrowing (the interest cost of 5%).

Hope this example helps you understand the impact leverage can have on returns.  I'll give a different view on this in the next post.

Happy studying!

Check out the signboard for The Spaulding Group's PMAR Conference, to be held next week in Philadelphia!  As you can see, our theme is superheroes!  There is still space, if you want to attend, contact Patrick Fowler or Chris Spaulding!

A little piece on GIPS...

Earlier this week, I wrote a guest blog post for STP Investment Services on the What, Why and Who of the GIPS Standards.  Good summary info for CIPM Principles candidates!

Read the blog post here!

GIPS: Supplemental Information vs. Additional Information

In the world of GIPS compliance and composite presentations, there is "supplemental information" and there is also "additional information"... but what is the difference?

When I explain these concepts to students in The Spaulding Group's classes or to our verification clients, I tell them it is helpful to think of the following concepts:

• required information:  any information that is required by the provisions of GIPS, or by any guidance statements, Q&As, the GIPS Handbook, gipsstandards.org, updates or clarifications from the GIPS Executive Committee, etc.
   
• recommended information:   any information that is recommended by the provisions of GIPS, or by any guidance statements, Q&As, the GIPS Handbook, gipsstandards.org, updates or clarifications from the GIPS Executive Committee, etc.
  
• additional information:  information that is required or recommended by the GIPS Standards
   
• supplemental information:  Any performance-related information included as part of a compliant presentation that supplements or enhances the required and/or recommended provisions of the GIPS standards 

For example, let's say a firm is showing both gross-of-fees and net-of-fees returns in a compliant composite presentation.  Can the firm label either the gross returns or the net returns as supplemental information?

The answer is no, gross return and net returns must not be labeled as supplemental information, because they are additional information.  GIPS provision I.5.A.1.b requires firms to show either gross returns or net returns (whichever is shown  must be clearly labeled as such).  But because gross returns and net returns are covered by the requirements of GIPS (i.e., they are required information), they fall under the category of "additional information" and cannot be labeled as supplemental information.  To do so could be interpreted by a reader of the composite presentation as de-emphasizing what is really a required presentation element.  True, GIPS provision I.5.A.1.b allows the firm to show gross returns or net returns, but a firm showing both cannot de-emphasize one of the returns by labeling it as supplemental.

Note:  supplemental information must be clearly labeled in a composite presentation.  Normally, required information, recommended information and additional information would not be labeled as such.

GIPS and return calculations: TWR vs. IRR - When Do We Use Each?

CIPM Expert Level candidates must know what return calculations are required by the Global Investment Performance Standards (GIPS(r)), and in which circumstances. 

Most of the time, time-weighted return (TWR) is required, but in some cases a since inception internal rate of return (SI-IRR) must be used. 

But what are the specifics?  Here is a breakdown:

• Generally speaking, i.e., if the real estate provisions of GIPS and the private equity provisions of GIPS do not apply (sections I.6 and I.7, respectively), then time-weighted returns are required by GIPS provision I.2.A.2.
• Total returns (i.e., that include gain/loss and income/expense) must be used (provision I.2.A.1).
• Either gross-of-fees or net-of-fees may be used, as long as clearly labelled (provision I.5.A.1.b).
• Gross is recommended (provision I.5.B.1).

• If the private equity provisions of GIPS (section I.7) apply, then since-inception internal rate of return is required (provision I.7.A.3).
• Total returns (i.e., that include gain/loss and income/expense) must be used (provision I.2.A.1).
• Both gross-of-fees and net-of-fees must be presented (provision I.7.A.21).

• If the real estate provisions of GIPS apply (section I.6), then time-weighted returns are required (provision I.2.A.2).
• In addition to total returns (which reflect gain/loss and income/expense) required by provision I.2.A.1), component returns must be presented (provision I.6.A.9).  Component returns are the capital return (gain/loss) and the income return (income/expense).
• Either gross-of-fees or net-of-fees may be used, as long as clearly labelled (provision I.6.A.14).

• If the composite in question is a closed-end real estate composite, then both time-weighted returns and since inception internal rates of return must be presented.
• For closed-end real estate composites,  with respect to time-weighted returns, the general requirements for real-estate composites must be met; i.e., calculation of total return, capital return and income return, which may be shown either gross- or net-of-fees (provisions I.2.A.2, I.2.A.1, I.6.A.9 and I.6.A.14).
• Firms must present the net-of-fees since-inception internal rate of return (provision I.6.A.23).
• If the firm shows gross-of-fees since inception internal rate of return, it must be shown for the same periods ;for which the net-of-fees SI-IRR is presented.

So, as you can see, it can become a bit involved when trying to determine whether to use TWR or SI-IRR, what is required vs. what is recommended, and is it a net- or gross-of-fees return that should or must be used.  The above bullets should spell out all of the scenarios.

Hope this helps!

Correction to Exercise on Sample Exam (Principles Level)

Last week, when I was teaching The Spaulding Group's CIPM Exam prep class for the Principles Level, a student asked me for help with a question on a sample exam from CFA Institute.  The question read:

Which of the following is most likely not a requirement of the GIPS standards for Presentation and Reporting?

a.       Annualizing returns for periods of less than one year.

b.      Presenting the total return for the benchmark for each annual period.

c.       Presenting the percentage of composite assets represented by non-fee-paying portfolios.

The sample exam stated that “b” was the correct answer, and the explanation states that the answer choice of “b” is not a requirement.

I indicated to the class that this appeared to be an error, as presenting the total return for the benchmark as of the end of each annual period is definitely required by GIPS provision I.5.A.1.e.   It seemed to me that the choice of "a" was the correct answer as we must never annualize returns of less than a year (GIPS I.5.A.4).

I later learned that the candidate that asked the question had a copy of an old sample exam, and that the question had been reworded as follows on the most recent copy of the sample exam:

           Which of the following is most likely a requirement of the GIPS standards for Presentation

           and Reporting?

          A.      Annualizing returns for periods of less than one year.

          B.      Presenting the total return for the benchmark for each annual period.

          C.      Presenting the percentage of composite assets represented by non-fee-paying portfolios.

This time, the answer key indicated that "C" was the correct response.   While it is true that item "C" is a requirement, it is also true that item "B" is a requirement, based on GIPS provision I.5.A.1.e, as I indicated above.

To end this long story, I contacted CFA Institute, and they indicated that this is indeed an error, which will be corrected.    Thus, I wanted to pass this on to candidates who may have been perplexed by this question.  And if you are a Principles Level candidate and were perplexed by the question, don't feel bad... I passed this by my Expert Level class students last week, and an interesting debate ensued with views all over the map.  So, sometimes this stuff is not so easy!