Learning Module 3: Overview of the Global Investment Performance Standards (GIPS)

1. Objectives and Scope

LOS: Discuss objectives, scope, and benefits of GIPS standards.

Mission: Promote ethics/integrity and instill trust through universal adoption.
Objectives:
1. Promote investor interests and confidence.
2. Ensure accurate and consistent data.
3. Worldwide acceptance of a single standard.
4. Promote fair, global competition.
5. Promote industry self-regulation.
Scope:
- Applies to Investment Firms and Asset Owners (managing discretionary assets).
- Consultants/Software vendors cannot claim compliance.
- Compliance is Firm-wide (cannot be partial).
Key Principles:
- Fair Representation & Full Disclosure.
- Voluntary ethical standard (must comply with local law; if conflict exists, follow law and disclose conflict).

LOS: Explain fundamentals including definition of the firm and discretion.

Requirement: Must be a distinct business entity held out to the public.
Criteria: Organizationally/functionally segregated, retains discretion, autonomous decision-making.
Total Firm Assets: Includes all assets (discretionary/non-discretionary, fee-paying/non-fee-paying). Includes sub-advised assets. Excludes advisory-only.
Recommendation: Broadest meaningful definition.

Concept: Ability of the firm to implement its intended investment strategy.
Requirement: Firm must document a definition of discretion.
Non-Discretionary: If client restrictions (e.g., “do not sell legacy holdings”, “no derivatives”) materially hinder the strategy, the portfolio is non-discretionary.
Impact: Only discretionary portfolios are included in composites.

LOS: Discuss TWR, external cash flows, cash equivalents, expenses/fees.

Mandate: Must use TWR (removes effect of external cash flows) unless eligible for Money-Weighted Return (MWR).
Methodology:
- Large Cash Flows: Must revalue portfolio and calculate sub-period return on date of flow. (Firm defines “Large”).
- No Large Cash Flows: Use daily weighted methods (e.g., Modified Dietz).
- Formula (True TWR): Chain-link sub-period returns. \[R_{TWR} = (1+R_1) \times (1+R_2) \dots - 1\]

Use when: Firm controls cash flows (closed-end funds, private equity) OR illiquid assets are dominant.
Metric: Internal Rate of Return (IRR). Since 2020, must use daily cash flows.

Cash: Returns from cash/equivalents must be included in total return (even if custodied elsewhere or “frictional”).
Transaction Costs: Returns must be Net of transaction costs (commissions, spreads).
- Custody fees are NOT transaction costs.
Bundled Fees: If transaction costs cannot be separated, deduct the entire bundled fee.

LOS: Explain the recommended valuation hierarchy.

Principle: Use Fair Value.
Frequency: At least monthly (TWR) or annually (MWR/Private Market).
Hierarchy (Waterfall):
1. Objective, observable, quoted prices for identical investments in active markets.
2. Quoted prices for similar investments in active markets.
3. Quoted prices for identical/similar in inactive markets.
4. Market-based observable inputs (other than quoted prices).
5. Subjective, unobservable inputs.

LOS: Explain requirements for composite return calculations.

Composite: Aggregation of portfolios with similar mandate/strategy.
Calculation: Asset-weighted average of portfolio returns.
- Method 1 (Beginning Assets): \[R_C = \frac{\sum (R_{pi} \times V_{0,pi})}{\sum V_{0,pi}}\]
- Method 2 (Beginning + Weighted Cash Flows): Denominator adjusts for external flows (like Modified Dietz denominator).
Prohibition: Simple average of portfolio returns is not permitted.

LOS: Explain “discretionary” context, role of mandates, and inclusion/exclusion rules.

Composites defined by investment mandate/objective/strategy (e.g., “Large Cap Growth”).
Rule: All actual, fee-paying, discretionary segregated accounts must be in at least one composite.
Non-fee-paying discretionary portfolios may be included (with disclosure).
Non-discretionary portfolios must not be included.

New Portfolios: Include on a timely, consistent basis (e.g., first full month after fully invested).
Terminated Portfolios: Include in historical history up to the last full measurement period of discretion. Do not remove history.
Switching Composites: Only if client mandate changes or composite is redefined. Historical history remains in the old composite.
Minimum Asset Levels: Firms may set a minimum size. If a portfolio falls below, it is removed prospectively (history stays).
Significant Cash Flows: Firm may define a level where a flow is “significant” and temporarily remove the portfolio from the composite (or use a temporary new account) to avoid skewing results due to trading drag.

LOS: Explain reporting requirements and portability.

Must provide to all prospective clients.
History: Minimum 5 years (or since inception) initially, building to 10 years.

Returns: Composite and Benchmark (Annual).
Assets: Composite assets and Total Firm assets (Year-end).
Count: Number of portfolios (if \(\ge 6\)).
Dispersion: Internal dispersion of individual portfolio returns (e.g., High/Low, Std Dev). Required if \(\ge 6\) portfolios for full year.
Risk: 3-Year Annualized Ex-Post Standard Deviation (Composite and Benchmark).

Performance from a past firm can be linked to a new firm ONLY IF:
1. Substantially all decision makers moved to new firm.
2. Decision-making process remains substantially intact/independent.
3. New firm has records to document history.
4. No break in the track record.
If there is a break: Can use history as supplemental info (if 1-3 met) but cannot link.

LOS: Discuss purpose, scope, and process of verification.

Status: Recommendation (not required).
Scope: Must be Firm-wide. Cannot verify a single composite.
Purpose: Independent third-party assessment that:
1. Policies/procedures are designed in compliance with GIPS.
2. Policies/procedures are implemented firm-wide.
Benefit: Increases credibility of the claim of compliance.
Note: Does not ensure accuracy of every specific composite report (that requires a specific “Performance Examination”).