CFA Level 1 - Section 1: Ethics - Reading 4 & 5: Introduction to the Global Investment Performance Standards (GIPS)

What the "Nine Major Sections of the GIPS Standards?"

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.

Composites

A composite is defined as a group of portfolios that are managed with the same strategy or objective. Rather than presenting the performance of each individual portfolio, the firm can simply disclose the composite return of the portfolios as a group. The determination of which portfolios to include in the composite should be done according to preestablished criteria (i.e., on an ex-ante basis), not after the fact. This prevents a firm from including only their best-performing portfolios in the composite. The composite return is the asset-weighted average of the performance results of all the portfolios in the composite. The following is not required for the Level I candidate but is provided as a reference only. Composite construction: 1.) All actual, fee-paying, discretionary portfolios must be included in at least one composite. 2.) Firm composites must be defined according to similar investment objectives and strategies. 3.) Composites must include new portfolios on a timely and consistent basis soon after the portfolio is being managed. 4.) Terminated portfolios must be included in the historical record up to the last full measurement period that the portfolio was under management. 5.) Portfolios must not be switched from one composite to another unless this change is documented in the client guidelines or if there is a redefinition of the composite. The historical results must remain with the old composite. 6.) Convertible and other hybrid securities must be treated consistently across time and within composites. 7.) Before January 1, 2010, if a single asset class was carved out of a multiple-asset portfolio and the returns presented as part of a single-asset composite, cash must be allocated to single-asset returns and the allocation method must be disclosed. 8.) From January 1, 2010 on, carved-out returns must not be included in single-asset-class-composite returns unless the assets are actually managed separately and have their own cash allocations. 9.) No model or simulated performance may be linked to actual performance. Composites must include only assets under management.

Section 3.) Calculation Methodology.

Achieving comparability among firms' performance presentations requires uniformity in the methods used to calculate returns. The standards mandate the use of certain calculation methodologies for both portfolios and composites. For example, total returns methodology is required for compliance. Total returns include realized and unrealized capital gains/losses, interest (accrued during a valuation period), and dividends paid (considered paid on the ex-date).

Section 6.) Presentation and Reporting.

After completing steps one to four, firms should incorporate this information in GIPS-compliant presentations.

What are the appropriate disclosures when the GIPS standards and local regulations are in conflict?

Appropriate disclosure when the GIPS standards and local regulations are in conflict: GIPS standards serve as minimum worldwide standards. If local laws are stricter than GIPS, local laws should be applied. If local laws don't exist or are less strict than the GIPS, the GIPS should apply. In cases of conflicts with GIPS, the standards require that local laws and regulations take precedence over GIPS. Firms should disclose any conflicts.

Section 4.) Composite Construction.

Creating meaningful asset-weighted composites is critical to the fair presentation, consistency, and comparability of results over time and among firms.

What is the Definition of a "Firm?"

Definition of the Firm: It is intended that GIPS compliance be available to any firm. A firm must comply with GIPS on a firm-wide basis to claim compliance with the standards. All actual, fee-paying, discretionary portfolios managed by the firm must be included in the performance-measurement process. To be in compliance, an entity must state how it defines itself as a firm. 1.) A firm may be defined as an investment firm, subsidiary or division held out to be a distinct business unit for managing investment assets. It could be part of a larger organization. 2.) Total firm assets must be the aggregate of the fair value of all discretionary and nondiscretionary assets under management within the defined firm. This includes both fee-paying and non-fee-paying assets. 3.) Firms must include the performance of assets assigned to a sub-advisor in a composite, provided that the firm has discretion over the selection of the sub-advisor. 4.) Changes in a firm's organization are not permitted to lead to alteration of historical composite results.

Section 5.) Disclosure.

Firms must disclose certain information about their performance presentations and policies adopted. Disclosures are considered to be static information that does not normally change from period to period.

How is "Historical Performance Record" defined by the CFA?

Firms should present their long-term performance records. To be in compliance, a firm must: 1.) Initially present a minimum of five years of compliant annual investment performance results, except for composites which have been in existence for less than five years (in which case, composite performance since inception must be presented). 2.) Add an additional year of compliant performance results each year until they reach 10 years of results. The goal is to have 10 years of GIPS-compliant performance results presented. To encourage firms to participate, GIPS only requires five years of data to initially come into compliance, allowing the full 10 years of performance results to be built over time. There is nothing to prevent a firm from initially presenting a full 10 years of compliance results. To maintain compliance, a firm presenting less than 10 years of performance results must increase the number of years of performance results presented.

Section 2.) Input Data.

Input data requirements set standards for the collection of data necessary for calculating performance results that will be comparable across firms. For example, benchmarks and composites should be created / selected on an ex-ante basis, not after the fact.

What are the Key Characteristics of GIPS?

Key Characteristics of GIPS? 1.) Firm definition: a direct business entity. 2.) GIPS are ethical standards, not legal standards, for performance presentation. The objective is to present performance results fairly and with full disclosure. 3.) Composites: All actual, fee-paying, discretionary portfolios must be included in at least one composite. 4.) Calculation and presentation requirements. 5.) The integrity of input data. 6.) There are two components: requirements and recommendations. 7.) Appropriate disclosure when local laws or regulations conflict with the standards. 8.) The eight sections of GIPS standards. 9.) The standards will evolve to address new aspects of investment performance.

What are the Objectives of GIPS?

Objectives: 1.) Obtain worldwide acceptance of a standard for the calculation and presentation of investment performance in a fair, comparable format that provides full disclosure. 2.) Ensure accurate and consistent investment and performance data for reporting, record keeping, marketing, and presentation. 3.) Promote fair, global competition among investment firms for all markets without creating barriers to entry for new firms. 4.) Foster a notion of industry self-regulation on a global basis.

Why were the GIPS Standards Created?

The financial markets and investment management industry has become increasingly global in nature. A common problem when reporting investment performance across different borders is that some countries have performance measurements and disclosures that are tailored specifically to them but that differ greatly from those in other countries. Some countries do not even have any standardized approaches for investment firms to follow to ensure fair representation and full disclosure of performance information. In the past, making meaningful comparisons on the basis of accurate investment performance data was difficult because of some misleading practices, such as: 1.) Representative accounts. Only the results of the best portfolio or securities are presented. 2.) Survivorship bias. For example, many mutual fund databases provide historical data about only those funds that are currently in existence. As a result, funds that have ceased to exist due to closures or mergers do not appear in these databases. Generally, funds that have ceased to exist have lower returns relative to the surviving funds. Therefore, the analysis of a mutual fund database with survivorship bias will overestimate the average mutual fund return because the database only includes the better-performing funds. 3.) Varying time periods. Only the results for profitable time periods are reflected. 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.

What is the Goal / Purpose of GIPS?

The overall purpose of GIPS is to provide guidelines for fair and full disclosure of investment performance. This will allow current and potential clients to properly interpret investment results over time and between firms. There are four goals of GIPS: 1.) Bolster investor confidence by ensuring the completeness, fairness, and standardization of calculation and presentation of investment performance on a global basis. 2.) Serve as a minimum standard to which all investment managers in the world should adhere. 3.) Enable global investment management firms to present performance results that are comparable with firms in other countries. 4.) Facilitate communications between investment managers and their prospective clients on evaluating historical performance results and developing future strategies. In 1999, the Investment Performance Council (IPC) was created to provide an implementation structure for the GIPS standards. All countries are encouraged to adopt the GIPS standards as the common method for calculating and presenting investment performance. When applicable local or country-specific laws or regulations conflict with the GIPS standards, firms should comply with the GIPS standards in addition to those local requirements. As of January 2010, more than 32 countries had adopted or were in the process of adopting the GIPS standards. Now IPC is entering its second phase of the convergence strategy to the GIPS standards: to evolve the GIPS standards to incorporate local best practices from all regional standards.

Section 8.) Private Equity

This section applies to all private equity investments other than open-end or evergreen funds. Private equity refers to any investment in nonpublic companies. Examples include venture investing, buy-out investing, mezzanine investing, fund-of-funds investing, secondary investing, etc.

Section 7.) Real Estate.

This section applies to any real estate investment or management. It applies regardless of a firm's control over the management of the investment, its profitability, or its financing.

Section 9.) Wrap Fee/ Separately Managed Account (SMA) Portfolios.

This section applies to wrap fee/ SMA portfolios. A wrap fee is a comprehensive charge levied by an investment manager or investment advisor on a client for providing a bundle of services, such as investment advice, investment research, and brokerage services.

Section 1: Fundamentals of Compliance.

This section deals with firm definition, policies and procedures documentation, compliance claiming, and the fundamental responsibilities of a firm. Document Policies and Procedures: Firms must document, in writing, the policies and procedures used in establishing and maintaining compliance with all the applicable requirements of the GIPS standards. Fundamental Responsibilities: 1.) Firms must provide a compliant presentation for any listed composite, along with a composite description, to all prospective clients. 2.) Discontinued composites must be listed for at least five years after discontinuation. Firms cannot alter their performance history by excluding portfolios no longer under management or no longer managed by the same manager, or by including the performance of portfolios managed by current employees before they started working for the firm. 3.) Firms should establish procedures to monitor GIPS requirements and the firm's performance measurements and presentations to ensure continued compliance.

Verification

Verification refers to the independent review of a firm's performance measurement processes and procedures. Verification applies to the firm as a whole, not to individual composites. Verification tests: 1.) Whether the firm has complied with GIPS composite construction requirements on a firm-wide basis. 2.) Whether the firm's processes and procedures are designed to calculate and present GIPS-compliant performance results. Again, the focus of verification is not on individual composites, but on the processes the firm follows to form composites and calculate and report performance. At this point, verification is not mandatory, but it is strongly recommended. Firms may claim compliance, but independently-verified compliance adds credibility to those claims. It is recommended that firms have all years for which they are claiming compliance verified.

What is the Vision of GIPS?

Vision Statement: A global investment performance standard leads to readily accepted presentations of investment performance that present: 1.) Performance results that are readily comparable among investment managers, without regard to geographic location, and 2.) Facilitate a dialogue between investment managers and their prospective clients about the critical issues of how the manager achieved performance results and future investment strategies.

What requirements does a firm need to meet to claim CFA "compliance?"

Which version of GIPS standards should firms comply with? The revised GIPS standards were adopted in 2010 and became effective on January 1, 2011. Although early adoption of these revised GIPS standards is encouraged, firms can still use the old version for performance presentations that include results through December 31, 2010. In order to claim compliance, a firm must meet ALL the requirements set forth in GIPS. Firms that fully comply with GIPS may use the following compliance statement in their performance presentations: "[Name of the firm] has prepared and presented this report in compliance with the Global Investment Performance Standards (GIPS)." With regard to compliance, a firm is either in compliance or not in compliance. Firms may not make any claims to being "in compliance except for..."

Who are the Parties Affected by GIPS?

Who are the Parties Affected by GIPS? 1.) Firms: * The GIPS standards apply primarily to investment management firms. The performance results of firms adopting GIPS will be more readily comparable. However, while firms are encouraged to adopt GIPS, the standards are voluntary. 2.) CFA Institute's Members, CFA Charterholders, and CFA Candidates * GIPS are a way of ensuring that no material misrepresentation of performance takes place. * GIPS satisfy Standard V (B) Communication with Clients and Prospective Clients. * Members, charterholders and candidates should inform employers of GIPS and encourage their adoption (though this is not mandatory). 3.) Prospective and Current Clients: * They are the primary beneficiaries of GIPS. * GIPS allow effective comparisons; they can directly compare the performance results of firms adopting GIPS. * Clients must still use due diligence.