As we draw near the December 31, 2020 adoption date for GIPS 2020, it will become increasingly important for firms to review the updated standards to determine whether any changes should be made, or more importantly, must be made to their existing policies and procedures to remain compliant.

While some of the changes and updates made in GIPS 2020 will result in the simplification of existing policies and procedures, others will require firms to assess, create, and adopt new ones altogether. We recommend that firms perform a gap analysis of their current policies and procedures in an effort to determine whether, at a minimum, all new requirements of GIPS 2020 have been met.

This article seeks to cover some of the changes and updates brought about as a result of GIPS 2020 that we anticipate will have an impact on many firms’ policies and procedures. It is important to note that this article is not meant to be all encompassing and, as a result, firms should review the updated standards in their entirety to understand the full impact of GIPS 2020.

Creating and Updating GIPS Reports

An area of the standards that has seen notable change, and is likely to impact a large number of firms, involves the creation and updating of GIPS reports. Before digging into these updates, it should be pointed out that GIPS 2020 replaced some keywords from the prior edition as well as introduced some new terminology that firms should take into consideration when updating their policies and procedures.

First and foremost, GIPS 2020 eliminates the use of GIPS compliant presentations and replaces it with GIPS reports. There are two distinct types of GIPS reports, each with their own set of requirements and recommendations. GIPS composite reports are more or less the same report one might associate with a GIPS compliant presentation. The GIPS pooled fund report is a new concept introduced by GIPS 2020 and is a presentation for a specific pooled fund.

In addition, GIPS 2020 introduces a model centered around portfolio types, which are then used as the basis for creating, updating, and distributing GIPS reports. As a result, firms will need to examine and segregate managed portfolios into one of three categories, each of which has been defined below:

• Segregated Account – a portfolio owned by a single client
• Broad Distribution Pooled Fund (BDPF) – a pooled fund that is regulated under a framework that would permit the general public to purchase or hold the pooled fund’s shares and is not exclusively offered in one-on-one presentations (i.e. mutual fund)
• Limited Distribution Pooled Fund (LDPF) – any pooled fund that is not a BDPF (i.e., hedge fund)

When creating composites, firms were previously required to include all actual fee-paying, discretionary accounts in at least one composite. However, under GIPS 2020, firms are now only required to include all actual, fee-paying segregated accounts in at least one composite. Pooled funds no longer need to be included in separate composites so long as the strategy is not offered for segregated accounts. As a result, previously kept pooled fund composites, often referred to as single-member composites, may be terminated. If the same strategy is offered for both pooled funds and segregated accounts, GIPS 2020 requires firms to include the pooled fund as part of the composite strategy. Furthermore, firms are prohibited from excluding one from the other based on legal structure alone.

Firms are required to create and maintain a GIPS Composite report for each composite strategy and a GIPS Pooled Fund report for each LDPF. Due to the complexities and regulatory requirements surrounding BDPFs, GIPS 2020 does not require firms to create and maintain GIPS Pooled Fund reports for BDPFs. While not required to do so, firms are not prohibited from creating a GIPS Pooled Fund report for a BDPF or including a BDPF in a GIPS Composite report. As indicated in the aforementioned paragraph, firms are required to include a BDPF in a composite if it meets the definition of a composite maintained for segregated accounts.

When updating GIPS Reports for distribution under the new standards, firms are now required to update reports to include information through the most recent annual period end within 12 months of that annual period end. In other words, when presenting calendar year-end periods, a firm must present the December 31, 2020 year-end returns no later than December 31, 2021. While most firms’ policies and procedures may stipulate that GIPS reports are to be updated at least annually, failure to do so now has the potential to jeopardize a firm’s compliance.

Distribution of GIPS Reports

The introduction of the portfolio type model brought about by GIPS 2020 resulted in changes made to the requirements governing the distribution of GIPS reports to prospects. The term “prospective clients,” for instance, was bifurcated into prospective clients and prospective investors. While a prospective client still represents any person or entity interested in one of a firm’s composite strategies, a prospective investor represents any person or entity interested in one of the firm’s pooled funds.

As it relates to the distribution of GIPS reports to prospective investors, differences exist in the requirements for BDPFs and LDPFs. Similar to composite strategies for prospective clients, prospective investors interested in LDPFs must be provided with an updated GIPS composite or GIPS pooled fund report at least once every 12 months. When providing a GIPS report to a prospective LDPF investor, firms have the option of providing either a GIPS pooled fund report or a GIPS composite report so long as the pooled fund is included within the composite. Firms are not required to distribute GIPS reports to prospective investors interested in BDPFs as a result of the nature of the investment and the availability of information.

One of the more important changes related to the distribution of GIPS reports is the requirement for a firm to demonstrate that it made every reasonable effort to provide GIPS reports to prospective clients and investors. This may require firms to develop more robust policies and procedures surrounding the tracking of such distribution. Sound policies and procedures should provide firms with pertinent information such as when a party initially became a prospective client or investor, which GIPS report was last provided, and when the next report is required to be provided. It should be emphasized that new verification requirements require verifiers to test this area as part of procedures performed. As such, it will be important to have tracking policies and procedures in place going into 2021.

Firm Assets

As part of the presentation requirements under the 2010 GIPS Standards, firms had the choice of presenting either total firm assets or composite assets as a percentage of total firm assets, as of each annual period end. GIPS 2020 removes that election and requires that all firms present total firm assets as of each period end. It is important to note that firms that have historically presented composite assets as a percentage of total firm assets need not retroactively update GIPS reports, as this option is still permissible for periods ending prior to December 31, 2020.

While not specifically addressed within the 2010 edition of the GIPS standards, firms previously relied on the guidance provided within the Guidance Statement on the Use of Supplemental Information when presenting advisory-only assets. GIPS 2020 specifically provides guidance on the use of advisory-only assets within GIPS reports. When presenting advisory-only assets, firms have the option to present amounts separately from total firm assets or combined with total firm assets, but presented as a separate value. Regardless of the decision, firms are still required to present total firm assets as a separate and identifiable value. It is worth mentioning that the presentation of advisory-only assets pertains to both firm-level assets as well as composite-level assets.

Non-Fee-Paying Portfolios

When opting to include non-fee-paying portfolios in a composite, firms were previously required to present the amount of composite assets represented by the non-fee-paying assets. However, under GIPS 2020, firms are no longer required to present this measure when presenting gross-of-fee returns or net-of-fee returns with a model net down. Only when presenting net-of-fee returns where returns are reduced by actual management fees charged (which would exclude non-fee-paying portfolios) are firms required to present this figure.

Portability

Historically, policies and procedures on the topic of portability have been relatively straightforward – if the new or acquiring firm met the prescribed criteria, performance of the past firm was required to be linked. However, under GIPS 2020, firms may choose whether to link past performance. The criteria for portability remained consistent between editions, with the exception of an additional criterion clarifying that the track record between the past firm and the new or acquiring firm be continuous in nature, if the firm wishes to link performance. If a break in performance does exist, firms are still permitted to port historical performance of the past firm, but are restricted from linking this to current performance.

GIPS 2020 also offers some clarity surrounding the timing and transition associated with the acquisition of another firm or merger of two firms. When a firm acquires another firm or affiliation, the firm has one year to bring any non-compliant assets into compliance. Furthermore, assets of the acquired non-compliant firm must meet all requirements of the GIPS standards within one year of the acquisition date, on a going forward basis. It’s worth reiterating that the one-year grace period applies to non-compliant assets becoming compliant on a prospective basis. New or acquiring firms are not required to bring past performance into compliance unless they want to port the prior track record, in which case there is no time limit or constraint.

Wrap Composites and Estimated Transaction Costs

In the past, wrap-specific composites or composites containing wrap portfolios posed a problem for firms in that transaction costs were indeterminable. This made it difficult to calculate and present gross-of-fee returns. Oftentimes, firms resorted to presenting a combination of net-of-fee returns in addition to other supplemental information, such as pure gross-of-fee returns.

As part of GIPS 2020, firms are provided the ability to estimate transaction costs when, and only when, actual transaction costs are unknown. Included within the Explanations of the Provisions in Section 2 put out by the CFA Institute, reasonable approaches to estimating transaction costs include using actual transaction costs for portfolios that the firm manages in the same or similar strategy, or actual transaction costs for similar securities that trade in a similar market. Estimated transaction costs may take the form of a percentage or as a monetary value. Regardless of the methodology selected, it will be imperative for firms to have clear policies surrounding the calculation of the estimated transaction costs as well as procedures for maintaining proper supporting documentation.

GIPS 2020 has introduced numerous changes to improve the standards. The CFA Institute has issued an Explanation of the Provisions for each of the sections within the standards, which provides firms with additional practical guidance to help implement the GIPS Standards. While we have offered this as a summary of changes potentially impacting your GIPS policies and procedures, it will be important to understand how to implement these policies in your organization. For more guidance about changes to the standards potentially impacting your policies and procedures, or any other part of GIPS 2020, please contact us.

We would be pleased to provide further information related to this subject. For more information, contact Joshua E. Kramer, Manager, Audit & Accounting at jkramer@kmco.com. 

You may also like:

• The Top 5 Things You Need to Know About GIPS 2020
• GIPS Compliance Services for Investment Managers
• Free GIPS Initial Assessment

Overview of the Rules Under GIPS 2020

The error correction rules for firms are in provision 1.A.20 of GIPS 2020, which notes that firms must correct material errors in GIPS composite reports and must:

1. Provide the corrected GIPS composite report to the current verifier
2. Provide the corrected GIPS composite report to current clients and any former verifiers that received the GIPS composite report that had the material error
3. Make every reasonable effort to provide the corrected GIPS composite report to all current prospective clients and prospective investors that received the GIPS composite report that had the material error. The firm is not required to provide a corrected GIPS composite report to former clients, former investors, former prospective clients, or former prospective investors.

The rules for pooled fund reports mirror those for composite reports and can be found in Provision 1.A.21.

This provision seems pretty straightforward, except for one item. How does a firm determine if an error is material or not?

What’s Material?

In order to help explain the GIPS Standards, in the past the CFA Institute has issued GIPS Handbooks, which provide guidance and examples. Under GIPS 2020 for firms, the Handbook has been renamed Explanations of the Provisions. Many people still refer to this as the Handbook, and we will too in this article.

In the GIPS 2020 Handbook (or just Handbook for short), error correction and materiality guidance is presented for provisions 1.A.20 and 21. The Handbook also notes that an error, which can be qualitative or quantitative, is any component of a GIPS report that is missing or inaccurate.

In order to determine whether an error is material, the Handbook goes on to note that firms should start with the following:

Materiality Definition

An error (or item) is material if the magnitude of the omission or misstatement of performance information, in light of surrounding circumstances, makes it probable that the judgment of a reasonable person relying on the information would have been changed by the omission or misstatement.

This is a good definition as it gets to the crux of the matter whether or not the judgment of a reasonable person relying on the information would have been changed. This definition is consistent with the framework used in the accounting profession as well as frameworks used when weighing legal and SEC matters. Although quantitative measures are important, note that this is not a purely quantitative model and that judgment (qualitative analysis) is required in order to make a final determination.

We suggest that firms expand upon this materiality definition to create a framework. This can be done by adding the following:

Users

Materiality is influenced by the perception of the needs of GIPS report users who rely on those reports to make judgments about an investment manager’s performance. Users are viewed as a group, not as specific individuals.

Judgment Influence

In determining if an error could influence the judgment of a user (as defined above), users are assumed to:

• Have an appropriate knowledge of business and economic activities and performance reporting and a willingness to study the information in the GIPS reports with an appropriate degree of diligence;
• Understand that GIPS reports are prepared to levels of materiality;
• Recognize the differences in different methods for calculating and reporting performance;
• Make appropriate decisions on the basis of information in the GIPS reports.

Perspective of Materiality

Materiality considerations should include the entire GIPS report, rather than one line, number, or disclosure viewed in isolation. In addition, errors need to be evaluated along with other known errors (including uncorrected errors from prior periods). This article discusses this further below.

Quantitative and Qualitative Considerations

Although materiality is commonly expressed in quantitative terms, determination of materiality is a matter of professional judgment that includes both quantitative and qualitative considerations.

Why Can’t Materiality Just Be Quantitative?

We see a wide variety of approaches to materiality in practice, including some firms which adhere to simple numerical thresholds without taking into consideration context, multiple errors in one statement, non-numerical errors, and other concerns which require judgment.

When defining materiality, firms should consider many factors. Setting a single basis point limit (such as 20 basis points) as the sole determinant of materiality can be dangerous.

Materiality is a relative concept. For example, 20 basis points may be material on a return of 25 basis points; however, on a returns of 700 basis points, 20 basis points does not seem as significant. Also, such absolute factors are impossible to apply to all non-return figures and disclosures in a presentation.

Below we have listed several different types of errors. Many of the errors are the same quantitatively, but the reasons for the errors and impact on a presentation are different for each example. Is each error material or immaterial? These potential error scenarios illustrate that there are many types of issues that can trigger errors, and that a fixed, absolute definition of materiality is not flexible enough to effectively evaluate all potential errors and the impact to the users of a performance presentation. A relative framework, which involves judgment, is needed.

1. The composite return is off by 19 basis points.
2. The composite return is overstated by 19 basis points and correcting the difference would cause the manager to go from outperforming the benchmark to underperforming the benchmark.
3. The composite return is overstated by 19 basis points while the index return is understated by 19 basis points.
4. Every number on the presentation is 100 percent correct, but the notes are misleading.
5. The current year composite return is overstated by 19 basis points. Suppose every prior year composite return in the presentation has the same misstatement.
6. The composite return was overstated by 19 basis points to manipulate company bonus allocations to portfolio managers.
7. The composite return is off 19 basis points as a result of mispricing of the underlying securities; this caused the account to trigger a performance fee. Without the mispricings the account would not trigger the performance fee.
8. A U.S. manager’s composite presentation containing mutual funds only shows gross returns and the investment manager is registered with the SEC. All returns presented are correct, the presentation contains the required disclosures, but the SEC requirement to show net returns for composites containing mutual funds has been violated.

Bringing It All Together

We suggest that firms consider the following approach in evaluating whether errors are material.

1. Set quantitative thresholds and qualitative factors that trigger an error review. Trigger criteria don’t necessarily mean that an error is material. Rather, trigger criteria causes a review of the error by the firm. Trigger criteria might include:
   1. Returns off by more than X%
   2. Benchmark returns off by more than X%
   3. Dispersion off by more than X%
   4. When composite or fund AUM is off by more than X%
   5. When firm AUM is off by more than X%
   6. Number of accounts is off by more than X%
   7. Incorrect or missing disclosures
   8. Any other error or combination or errors that the performance team believes should be evaluated for materiality
2. Create a committee responsible for evaluating error materiality. Consider including the following team members on the committee:
   1. Performance professionals who are familiar with the GIPS Standards.
   2. Compliance professionals who are familiar with regulatory requirements and rules, such as those promulgated by the SEC.
   3. Investment professionals who understand the investment products being represented by the GIPS reports.
3. Use the materiality framework noted above to evaluate the errors. This might include the following:
   1. Recalculate the returns and quantify the error in the GIPS report. Any additional errors (including those from prior years that are still uncorrected) should be included in the analysis. The result is that the committee should be able to look at the current GIPS report with all errors identified. Maybe this is just one return. Maybe it’s the past 5 years’ returns and benchmark data. The point is to view the GIPS report as a whole when determining whether it’s misleading. Just analyzing one number, viewed in isolation, is generally not an effective method for determining whether the GIPS report is materially misstated. It is generally helpful to analyze errors both individually and in the aggregate.
   2. Determine if the error(s) are material based on the materiality definition and framework presented earlier in this article.
      1. For numeric errors, consider evaluating the error on both an absolute and relative basis. For example, 20 basis points may be material on a return of 25 basis points; however, on a returns of 700 basis points, 20 basis points does not seem as significant.
      2. For disclosure items (such as missing or incomplete disclosures), consider the impact of the error on a user of the GIPS report. Perhaps omitting a disclosure that indicates that the returns are calculated in USD is deemed to be immaterial, while omitting the required composite description is material.
4. Document the committee’s decisions and reasoning.
5. Follow the firm’s error correction policies:
   1. For material errors – the firm’s policies must follow the correction and distribution requirements of Provisions 1.A.20 and 21, including the redistribution of corrected reports to verifiers, clients, and prospective clients and investors who received the GIPS report that contained the material error. Also, the GIPS Standards require firms to disclose errors deemed material for a minimum of one year in the related GIPS report.
   2. For immaterial errors – the firm has more flexibility on whether to correct or leave the error uncorrected. Some firms do not make any changes under the rationale that it’s simply not material. Other firms correct the presentations. The key is to follow the firm’s policies and procedures consistently.
6. Maintain a log, which should include:
   1. A description of each error.
   2. Whether or not it was material.
   3. For material errors, to whom the corrected GIPS reports were sent.
   4. Any new policies and procedures implemented in order to minimize the risk of similar errors occurring in the future.

GIPS 2020 has introduced numerous changes to improve the standards. The Handbook provides additional practical guidance to help firms implement the GIPS Standards. While we have offered this overview of error correction and materiality determination, it is important to understand how to implement these policies in your organization. For more guidance about error correction, materiality, or any other part of GIPS 2020, please ccontact us.

We would be pleased to provide further information related to this subject. For more information, contact Thomas A. Peters, Director, Audit & Accounting at tpeters@kmco.com.

You may also like:

• The Top 5 Things You Need to Know About GIPS 2020
• GIPS Compliance Services for Investment Managers
• Free GIPS Initial Assessment

With the release of GIPS 2020 came another change to the standards on carve-outs, marking the second time in which the guidance has changed. So, we thought it might be worthwhile to revisit the history of carve-outs guidance within the GIPS Standards.

A Brief History

Initially, the GIPS Standards (formerly, AIMR Performance Presentation Standards) permitted the carving out of a portion of portfolio assets into individual segments for the creation of separate and distinct strategies. In understanding the importance of cash and its potential impact on performance, the standards required that cash be allocated to these carve-outs on a timely and consistent basis, if not already tracked using a separate cash account. With the release of the second edition of the GIPS Standards in 2005, firms were required to start disclosing the percentage of the composite represented by carve-outs as of each period end.

Fast forward to the release of the 2010 edition of the GIPS Standards, in which the GIPS Executive Committee determined that allocation of cash for carve-outs was no longer permitted. Advocates for this change argued that carve-out returns could potentially be misleading, as they did not portray a fair representation of the performance that would have been achieved with a portfolio dedicated to that strategy. Moreover, there existed a chance that prospective investors could be led to believe that that the firm had experience in managing portfolios dedicated to a specific strategy when that may not have been the case. As a result, carve-outs were permitted for inclusion in composites only if they had a separate cash account for the segment being carved out.

Jumping to present day, the GIPS 2020 Standards once again permit firms to allocate cash for carve-outs for inclusion within compliant GIPS composite reports. The change in heart came about primarily as an attempt to increase the number of firms claiming compliance with the GIPS Standards. The thought process was that by allowing firms to allocate cash to carve-outs, more private wealth managers and managers of private market investments, who are more accustomed to multi-asset portfolios, would be encouraged to claim compliance with the standards as they would no longer be tasked with the burden of tracking separate cash accounts.

As you might imagine, GIPS 2020 includes some additional requirements for firms electing to include carve-outs using a cash allocation. These additional requirements have been introduced in order to address the previously raised concerns.

“So we’re allowed to allocate cash, but how?”

Although GIPS 2020 is once again allowing firms to allocate cash to carve-outs, the standards do not prescribe a specific methodology for the allocation of cash. The only requirement related to the allocation of cash is that it is treated consistently and on a timely basis (3.A.15). As such, there is no single methodology required when allocating cash to carve-outs.

As noted in the adopting release for firms, the CFA Institute plans to include guidance within the GIPS 2020 Handbook regarding possible methods for allocating cash. No release date for the Handbook has been announced. Until such guidance is released, acceptable allocation methods have been provided within the previously-issued GIPS Guidance Statement on Treatment of Carve-Outs, which can be found on the GIPS website.

Two of the acceptable allocations methods included within the Guidance Statement are beginning of period allocation and strategic asset allocation. Under the beginning of period allocation method, each month cash is allocated to the carved-out segment based on the carve-out beginning market value as a percentage of the total portfolio beginning market value, excluding cash.

Under the strategic allocation method, cash is allocated to the carve-out based upon target strategic asset allocation. An example might include a manager with a 60/40 equity to fixed income portfolio. If, at the beginning of the period, the portfolio held 56 percent in equites and 38 percent in fixed income securities, then 4 percent of the cash would be allocated to the equities segment and 2 percent to the fixed income segment.

Regardless of the allocation methodology selected, GIPS 2020 requires firms to disclose the policy within the compliant GIPS composite report (4.C.28).

Additional Requirements

As was the case in 2010, skeptics of the new carve-out guidance within GIPS 2020 argued that the use of carve-outs could potentially be misleading to prospective investors as the related performance may not necessarily be representative of a standalone portfolio in a dedicated strategy. In an effort to make the inclusion of carve-outs as transparent as possible, GIPS 2020 includes additional requirements for firms including carve-outs with a cash allocation in composites.

If a firm elects to include carve-outs with allocated cash in a composite, GIPS 2020 requires that it be representative of a standalone portfolio managed or intended to be managed. While this may sound intuitive, it prevents firms from carving out segments that may be misleading to a prospective investor. For instance, a firm is not permitted to carve out the two German equities included in its global balanced composite and create a German equities composite, as this would not be representative of a standalone portfolio.

Furthermore, GIPS 2020 requires firms to create carve-outs with allocated cash from all portfolios and portfolio segments within the firm that are managed to that strategy (3.A.17). As a result, firms will be prevented from cherry-picking which portfolios of a similar strategy will be carved-out with allocated cash and included in a composite.

To further address concerns related to carve-outs with allocated cash not being representative of a standalone portfolio, GIPS 2020 requires that once a firm has – or obtains – a standalone portfolio managed in the same strategy as the carve-outs with allocated cash, the firm must create a separate composite for the standalone portfolio(s) (3.A.18). As a result, it will not be uncommon for firms to have to two separate composites for the same strategy. The only difference between them would be that one includes standalone portfolios and the other includes carve-outs with allocated cash.

When calculating net-of-fee performance for carve-out segments, it will be important to determine the prospective investor and the target portfolio, whether it is a standalone portfolio or a multi-asset portfolio. GIPS 2020 requires the net-of-fee return calculation to be representative of the investment management fee that would be charged to a prospective investor. Furthermore, if actual fees are used, GIPS 2020 requires firms to allocate fees to each segment that are appropriate for each asset class (2.A.47).

How does this impact my presentation and disclosures?

GIPS 2020 further expanded upon the presentation and disclosure items required for composites that include carve-outs with allocated cash. Recalling from earlier, the 2005 edition of the GIPS Standards required firms to disclose the percentage of composites composed of carve-outs. Under GIPS 2020, the standards now specify that the percentage of composites must be presented only for carve-outs that allocate cash (4.A.6). As such, firms need not present the percentage of carve-outs that maintain separate cash accounts. The purpose of this was to provide a prospective investor with an idea of the portion of the composite not represented by a standalone portfolio.

To further drive home this point, GIPS 2020 requires composites including both carve-outs with allocated cash and standalone portfolios to present composite returns and asset market values of the standalone portfolios segment for each annual period end (4.A.13). As you might recall from earlier, composites will have already been created in connection with Provision 3.A.18 and as such, including the related returns and composite assets should be a relatively easy task.

Additional disclosures required by GIPS 2020 include indicating within the composite name that the composite includes carve-outs with allocated cash as well as disclosing that the GIPS composite report for the composite standalone portfolios is available upon request, if it exists (4.C.28).

Can I switch my accounts from cash account to allocation?

In response to the release of the new guidance on carve-outs, firms currently including carve-outs with segregated cash accounts may be enticed to start allocating cash to alleviate the administrative burden of tracking cash separately. For carve-outs already set up with a  segregated cash account, it may be easier to continue tracking cash separately, but what about for new accounts? Is it possible for a composite to include carve-outs with segregated cash accounts, carve-outs with allocated cash, and potentially standalone portfolios?

Under GIPS 2020, both standalone portfolios and carve-outs with segregated cash accounts are treated one in the same, while carve-outs with allocated cash must adhere to all of the new requirements prescribed within the 2020 GIPS standards.

Inclusive of these requirements is the provision to create carve-outs with allocated cash from all portfolios and portfolio segments within the firm managed to the same strategy. As such, firms electing to allocate cash to carve-outs for a strategy that once included carve-outs with dedicated cash accounts will now need to allocate cash for all carve-outs managed to that strategy. This change should be made on a prospective basis and firms should not restate previously reported performance.

Furthermore, this change would qualify as a composite redefinition and firms must disclose the date and description of any composite redefinition. As a result of this requirement, we expect firms will create carve-outs with allocated cash for strategies where they don’t have carve-outs with segregated cash accounts.

Conclusion

Changes to the GIPS Standards involving carve-outs have certainly evolved over time. GIPS 2020 offers a new take on carve-outs to broaden acceptance of the standards, while also addressing the noted concerns. While allowing the allocation of cash to carve-outs will hopefully draw new firms to the GIPS Standards, the additional requirements will safeguard prospective investors from being misled.

Although a majority of the new guidance introduced by GIPS 2020 regarding the allocation of cash to carve-out have been covered throughout this article, it will be important to make sure all requirements are met when making the election to allocate cash to carve-outs. For more guidance about GIPS 2020 and to schedule a conversation, please contact us.

And, if you already claim compliance with GIPS, consider taking advantage of Kreischer Miller’s free GIPS initial assessment, which will:

• Identify potential issues and areas for improvement, and
• Provide meaningful feedback about your current process.

Contact us for your free GIPS initial assessment.

The 2020 edition of the Global Investment Performance Standards (GIPS 2020) was released on June 30, 2019 and is effective beginning January 1, 2020. GIPS 2020 introduced a significant number of additions and changes, the most notable of which can be found in our “Top 5 Things You Need to Know about GIPS 2020” article.

Number two on our “Top 5” list, and perhaps the one with the most extensive changes from prior GIPS versions, is the treatment of pooled investment funds.

Below are four areas with key changes impacting firms that manage pooled vehicles.

Definitions

GIPS 2020 introduces two categories of pooled funds:

1. Broad Distribution Pooled Funds (BDPFs)
2. Limited Distribution Pooled Funds (LDPFs)

BDPFs are defined as pooled funds that are regulated under a framework that would permit the general public to purchase or hold the pooled fund’s ownership interests and that are not exclusively offered in one-on-one presentations. In other words, BDPFs are publicly-traded or retail funds, such as a 1940 Act fund or a UCITS fund. As a point of emphasis, the definition of BDPFs has been revised from the GIPS 2020 exposure draft and earlier guidance statement drafts based on feedback received from comment letters.

LDPFs are those pooled funds that cannot be classified as a BDPF. To put it another way, LDPFs are generally private funds, such as a hedge fund, a private equity fund, a limited partnership, or a collective investment trust.

For firms that market pooled funds, the first step under GIPS 2020 is to classify the pooled vehicle offerings as either BDPFs or LDPFs. This is important since certain provisions and reporting requirements within GIPS 2020, some of which are described below, are applicable to one category versus the other.

Categorization of a firm’s pooled vehicle offerings does not come without its challenges, however. Questions arise in situations such as a multi-share class fund. A comment letter response to the GIPS 2020 exposure draft was presented describing a publicly-traded pooled fund with both a retail and an institutional share class and with the institutional share class marketed only in one-on-one presentations. The adopting release that accompanied the issuance of GIPS 2020 laid out that the rules were not intended to have share classes themselves be classified. In this specific situation, the pooled fund would be a BDPF, because the fund is not exclusively offered in one-one-one presentations.

One item to consider related to classifying pooled funds, which may help in these other situations, is to evaluate the firm’s typical marketing practices. A firm should consider whether or not those marketing practices involve contact between the firm and the prospective investor (thus an LDPF) or do not involve contact (thus a BDPF). Further guidance and examples are expected to be provided in the GIPS 2020 Handbook when it is released.

Composite Inclusion

What will likely go down as the most welcome change, at least amongst fund managers, is that the guidance surrounding composite inclusion for pooled funds has been relaxed in GIPS 2020. Prior GIPS versions did not distinguish between separately managed portfolios or pooled portfolios when it came to composite creation and inclusion. To that end, investment firms that only managed pooled funds (e.g. an ETF only shop), were required to create a large number of single account composites to hold each of the pooled fund offerings. For those types of firms, compliance with the new iteration of the standards should be more easily attainable.

Under GIPS 2020, although pooled funds must still be included in a composite if they meet a composite definition, firms are only required to create composites for strategies that are managed for or offered as a segregated account. In other words, a firm is not required to create a composite that only includes pooled funds unless the firm also offers that strategy as a segregated account. Additionally, firms that created composites to house just pooled funds under past rules may terminate those composites under the new set of standards.

Similar to the definitions described above, this change to composite inclusion does not come without its challenges. Firms that manage both separate portfolios and pooled portfolios may actually see some additional complexities. A change to one provision related to how composites must be defined could create some interpretative challenges for these types of firms. A new sentence was added to that provision in the new rules that indicates a firm must not exclude portfolios from composites based solely on legal structure differences.

Under prior GIPS versions, specifically the Guidance Statement on Composite Definition, firms could use the portfolio type (i.e., separate portfolios versus pooled proposals) as a constraint when defining composites. Expressed in a different way, pooled funds could previously be treated as separate composites or combined with other portfolios of the same strategy.

The new sentence appears to contradict the previous guidance statement and, as such, firms that have both types of portfolios and that previously separated them may now need to combine them. As noted above, further guidance and a decision on whether past guidance statements still apply are expected to be provided in the GIPS 2020 Handbook.

Reporting

Reporting under GIPS 2020 has been changed significantly. Compliant presentations, which were previously utilized for all prospective clients regardless of type, are replaced by GIPS composite reports. Additionally, a second type of GIPS report – the GIPS pooled fund report – has been added. This report will be utilized in connection with a newly added and defined type of prospect, the prospective investor. Before comparing and contrasting the new report types, let us first discuss which report is utilized when.

Determining Which Report to Utilize

Reporting to prospective clients (i.e., those that qualify to invest in a composite) is largely unchanged under GIPS 2020. A firm must still make every reasonable effort to provide a GIPS composite report – similar in nature to the past compliant presentations – to prospective clients when they initially become a prospect and at least every 12 months, assuming they remain a prospective client.

From there, GIPS 2020 eliminated the confusion surrounding past versions as to what, if anything, should be provided to prospective investors. This is where the categorization of BDPFs and LDPFs comes into play, as noted above. For BDPF prospective investors, firms are not required to provide a GIPS composite report, which must include the BDPF if provided, or a GIPS pooled fund report. However, firms may elect to do so.

For LDPF prospective investors, firms must make every reasonable effort to provide a GIPS pooled fund report, or a GIPS composite report that contains the LDPF, when the investor initially becomes an LDPF prospect and at least every 12 months, assuming they remain an LDPF prospective investor.

One key point to reiterate is that regardless of whether it is a BDPF or LDPF investor, the GIPS composite report can only be utilized if that composite report contains the respective pooled fund in the composite.

Comparing and Contrasting GIPS Composite Reports and GIPS Pooled Fund Reports

The purpose of creating a GIPS pooled fund report was to afford a more appropriate method for providing GIPS-compliant information to prospective pooled fund investors. In that regard, there a few less requirements in a GIPS pooled fund report as compared to a GIPS composite report, such as the number of portfolios and a measure of internal dispersion.

One specific requirement of a GIPS pooled fund report that is not required of the GIPS composite report is the inclusion of the pooled fund expense ratio. The pooled fund expense ratio is similar to the expense ratio that a mutual fund would report in its annual financial statements. Overall, the two reports are similar, with the GIPS pooled fund report information being limited to that of the particular pooled investment vehicle. Fund managers may be able to leverage existing fund materials by integrating the GIPS reporting requirements into those materials. While this may create a few additional compliance checks internally, the overall result should be an easier path for fund managers to claim GIPS compliance.

Although this article discussed the two high-level GIPS reports (GIPS Composite Report versus GIPS Pooled Fund Report), one key point to mention is that there are actually four types of reports as a result of the expanded ability to use money-weighted returns (MWRs). Those four reports are:

1. GIPS Composite Report – Time-Weighted
2. GIPS Composite Report – Money-Weighted
3. GIPS Pooled Fund Report – Time-Weighted
4. GIPS Pooled Fund Report – Money-Weighted

In GIPS 2020, firms may present MWR if they have control over the external cash flows of the composite portfolios or pooled fund, and the composite portfolios or pooled fund has at least one of the following characteristics:

• Closed-end
• Fixed life
• Fixed commitment
• Illiquid investments are a significant part of the investment strategy

Other Reporting Matters

The following other reporting matters related to pooled investment vehicles were also addressed in GIPS 2020:

• Firms have a choice of presenting gross or net returns in a GIPS pooled fund report. The GIPS 2020 provisions allow for this so that firms can meet the various regulatory requirements in different countries. In the U.S., net is generally required.
• Firms must maintain a complete list of BDPFs (note that descriptions are not required) and a complete list of LDPFs with descriptions.
• Firms are not required to include terminated pooled funds on the above mentioned lists.
• Firms must provide the LDPF list with descriptions if requested, and that list may be tailored if the firm wishes to do so.
• Firms must provide the BDPF list if requested, and that list may be tailored if the firm wishes to do so. Alternatively, firms can direct a prospective investor to their website if a complete list is maintained there. Descriptions must also be provided upon request.
• It is recommended (not required) that firms selling participation in a new LDPF provide the prospective LDPF investor with a GIPS report containing the most appropriate (same or similar strategy) track record.

Advertising

Similar to composite inclusion, another welcome change for fund managers should be the broader application of the GIPS Advertising Guidelines, which remain voluntary.

First and foremost, consistent with the changes in the general GIPS 2020 provisions, the GIPS Advertising Standards also no longer have a composite-centric approach and will be broken down in sections related to composites, BDPFs, and LDPFs. In that regard, fund managers that wish to reference their GIPS claim of compliance in fund materials must adhere to the relevant sections of the GIPS Advertising Standards. Those managers that elect not to follow the advertising guidelines must make no reference to GIPS in advertisements.

The second key change in this area is that the definition of an advertisement has been expanded to include pooled fund fact sheets and pooled fund offering documents. This should allow firms to acknowledge their claim of compliance in documents such as a prospectus or in other fund-specific marketing materials.

In Conclusion

GIPS 2020 introduced significant changes for firms that manage pooled investment vehicles. Some additional internal procedures may have to be incorporated by fund managers, but overall, these changes should reduce the compliance burden and provide a more relevant and attainable path to GIPS compliance.

If you are a fund manager that claims compliance or are thinking about becoming compliant once the new standards are effective, you will be impacted by GIPS 2020. While this article offered an overview of the most significant changes in GIPS 2020 for pooled fund managers, it is important to understand how the new guidance will specifically impact your firm. For more guidance about GIPS 2020, please contact us.

And, if you already claim compliance with GIPS, consider taking advantage of Kreischer Miller’s free GIPS initial assessment which will:

• Identify potential issues and areas for improvement, and
• Provide meaningful feedback about your current process.

Contact us for your free GIPS initial assessment.