Cfa Level Iii - Study Session 18

Front 1

Why are there GIPS and why do people use them?

GIPS (SS18)

Back 1

1. Creates an industrywide performance measure to improve reliability and standardize the calculation.
2. Makes an ethical standard for fairly presenting historical performance records and disclosure.
In the past they showed only the best performing stocks, unsubstantiated estimates of asset prices, annualizing part period returns, choosing the best measurement period, showing simulated returns, choose a benchmark that they have outperformed and mask external cash flows as returns.
3. GIPS give clients greater confidence in what is presented and allows them to make reasonable comparisons.
4. Allows the company to compete in international markets, eliminates barriers to entry.
5. Improves the firms internal processes.
6. Can't claim compliance with an 'exception' - all or nothing

Front 2

Definition of the firm

GIPS (SS18)

Back 2

Only investment firms can claim compliance with GIPS

ONLY on a firmwide basis
NOT individuals
NOT individual products
NOT individual composites
NOT individual departments
NOT software providers
NOT consultants
NOT custodians

Front 3

What does GIPS say about the firm?

GIPS (SS18)

Back 3

A claim of compliance means:
1. Data inputs
2. Processes
3. Returns calculation methodology
4. All of the firms fee-paying discretionary portfolios have been assigned to a composite.
5. Disclosure
6. Reporting
7. Presentation
8. Special treatment for Real Estate and Private Equity

NOTE:
OK to have some non-fee accounts in your composite you just have disclose how much they comprise of the composite
NOT ok to have non-discretionary accounts in the composite
NOT ok to only have some fee-paying accounts in a composite. All of them have to be somewhere.

Front 4

Total Return Calculations for GIPS

GIPS (SS18)

Back 4

Time weighted return
1. BEFORE investment management fees
2. INCLUDING cash in portfolio returns calculations
3. Agreeing start date for the performance measurement with the client.
4. Choosing a style/risk appropriate benchmark for performance comparisons
5. Showing asset-weighted composites of investment performance.
6. Accrued income for bond market values
7. Temporary accounts for cash flows
8. Show at least a 5 year record for performance presentations or since inception. After 5 years is there they should build to 10.
9. Discontinued composites should remain on the list for 5 years after they are closed.

Front 5

What if countries have things more strict/different/conflict with GIPS?

GIPS (SS18)

Back 5

1. Firm should comply with local law or regulation
2. Firm has to disclose the difference between the local rule and GIPS in the performance presentation.
3. If they have a CVG Country Version GIPS, then they show that for 10 years.

Front 6

How is a firm defined for GIPS?

(SS18)

Back 6

1. Held out to clients or potential clients as a distinct business entity
2. Organizationally (e.g. UBS Asset Management, UBS Wealth Management) and functionally segregated from other units, departments, offices with own accounting, management, research and trading team.
3. Retains discretion over the assets it manages and autonomy over the investment decision-making process.
4. If you change the firm structure you have to leave past historical returns where they are. (i.e. if you choose good managers, then you can't just add their returns to your past returns to make them look better).

OK separate legal entity
OK distinct market type
OK distinct client type
OK separate and distinct business entity (e.g. Personal vs Institutional)

Front 7

What policies and procedures do you need to decide for yourself for GIPS?

(SS18)

Back 7

1. Criteria for inclusion into composites (e.g. min $100k)
2. Timing of inclusion/removal of new/terminated accounts from composites
3. The firms own definition of discretion
4. The firms treatment of cash flows
5. Firms opinion about how large does a 'large external cash flow' have to be

Front 8

Input Data

(SS18)

Back 8

1. All data should be captured and maintained
2. Use market values i.e. fair values as at valuation date.
3. Use trade date
(Starting Jan 1 2005)
4. Accrual accounting for fixed-income assets and dividends after ex-div date.
5. Value portfolios
quarterly prior to 2001
monthly 2001-2010
on date of all large cash flows 2010-on

NOT cost values
NOT book values
NOT settlement date
NOT interest when paid
NOT switching price sources just to make you look better.

Front 9

Calculation Methodology:
Simple Time-Weighted Total Return
MV₁ - MV₀
r = _________
MV₀

(SS18)

Back 9

1. Good for single period
2. Good for no external cash flows
3. This formula is used to calc the subperiod returns under the better intraperiod valuation method.
4. Returns are multiplicative, not additive (i.e chain link them)

Front 10

Better Time-Weighted Total Return
Original Dietz
Modified Dietz
Modified IRR

(SS18)

Back 10

1. Used if there are external cash flows.
2. Original Dietz uses midpoint for weighting external cash flows (period prior to 2005)
3. Modified Dietz uses actual daily weights. (Required after Jan 2005). This needs an iterative procedure to solve for return
4. These take a proportion of the days that the cash has been in the portfolio. How long has the new money been in the pf to help earn the returns?

NOT good for calc after 2010, where you need to weight on every external cash flow date.

Front 11

Return Calculations for external cash flows

(SS18)

Back 11

1. Flat market
Time = Modified = Original
2. Steadily rising market
Time 8 = Modified 7.93 = Original 7.99
the timing of cash flows has a small impact
3. Volatile market
Time 8 = Modified 8.64 = Original 9.52
large external cash flows have a material impact on the return

Front 12

Return Calculation Standards
What to do with cash

(SS18)

Back 12

1. Managers can decide how much cash to own, so it should be in the performance management calculation.
2. Rising market
Cash reduces returns
3. Falling market
Cash improves returns
4. Cash Allocation 4% return
Cash Outperformance by short-term money manager .5% (both rising and falling markets)

Front 13

Returns after actual trading expenses?

(SS18)

Back 13

1. Performance calculation has to include them
2. Explicit costs of commission etc
3. Actual trading expenses are a key piece of input data
4. Breaking trading expenses out of bundled fees. If you have wrap or bundled fees, you have to use the direct trading part of those fees to reduce the return on your fund. If you can't break them out include the WHOLE thing.
5. Withholding that you won't get back (from non-domestic securities) counts as a transaction cost.

NOT estimated
NOT including custody fees
NOT withholding that you will get back

Front 14

Composite Return Calculation Standards

(SS18)

Back 14

Composites are comprised of a bunch of accounts under the same style
1. Asset weight the composite using
Beginning of period values alone OR
Beginning period values + weighted external cash flows across the period.
2. Beginning + external, adds in the fact that each external cash flow is weighted in proportion to % of time it is in the portfolio for that period.
3. GIPS says asset calculating returns by
1 Jan 2006 by asset reweighting at least quarterly
1 Jan 2010 by asset reweighting at least monthly
The less you re-weight them, the more inaccurate you will be.

Front 15

Making Composites
What is discretionary?

(SS18)

Back 15

It's ALL about the manager being able to execute their strategy
"All actual fee-paying discretionary portfolios must be included in at least one composite"
1. Non-fee paying can be included with appropriate disclosures
2. Document how you make your composites. This means that you can see whether you ever need any new composites and that all pfs are in the correct composite i.e. their goals have not changed.

NOT permitted are any non-discretionary
NOT just some fee-paying, all. This avoids firms only showing their best accounts.
NOT discretionary if the client tells you how to invest
OK if the client has risk thresholds around given strategy stock/bond, that is still discretionary
OK if the client doesn't want alcohol/gaming, still discretionary
OK if the client wants to hold onto sentimental holdings, still discretionary
OK if client says don't use derivatives, still discretionary
NOT ok if client says no derivatives and you have a derivative strategy, this instance is non-discretionary.
NOT ok if client has big withdrawals each month and manager has to keep a high level of liquidity, this is non-discretionary.

Front 16

Guidance on composite definition

(SS18)

Back 16

a) Investment Mandate (Global Equities)
b) Asset class (equity or fixed income)
c) Style or Strategy (tele stocks, mining stocks, value or growth stocks)
d) Benchmarks (define it based on the benchmark that you assess it against, e.g. S&P500)
e) Risk/ Return characteristics (e.g. enhanced index funds matched to other enhanced index funds with similar return targets and tracking error tolerances)

Front 17

Too few composites?
Too many composites?

(SS18)

Back 17

Too few?
i) lumped together
ii) overly broad
iii) wide dispersion of returns
Too many?
i) expensive to maintain
ii) too narrowly defined
iii) too few accounts to be useful
iv) lose anonymity of individual client accounts.

Front 18

To include a pf into a composite?
To exclude a pf from a composite?
To switch a pf between composites?

(SS18)

Back 18

Composites must include new portfolios on a timely basis after the pf comes under management.
1. Add at beginning of next reporting period
2. Remove from end of prior reporting period
3. GIPS do give you room to move when to include/exclude them, but once you have made your policy you have to stick to it.
4. Leave terminated accounts history where it is.
5. Can switch if client says that they want to change their strategy
6. Can switch if you rejig your composites to a point where some pfs no longer match.

OK to exclude if client tells you to in the belief that they are going to add more money
OK to exclude if the account isn't fully funded yet.
NOT ok to remove whole past history of a pf that is terminated with you
NOT ok to switch pfs between composites to make results look better.

Front 19

Simulated returns for composites?
Any minimum asset levels?

(SS18)

Back 19

1. Only pfs in which actual assets have been invested, not hypotheticals can be included in composites.
2. If you define your minimum pfs value for a composite, you have to stick to it, even if the market tanks.

NOT ok to link simulated returns to actual performance returns
NOT ok to apply min pf levels retroactively.
NOT ok to market a composite to a prospective if the min $ required to invest is too high for them.
OK to have a threshold around your min. pf value policy rules so that it allows you some room to move without breaching the policy.
OK to show simulation in supplemental information

Front 20

Carve-outs for composites

(SS18)

Back 20

1. All in the name of fair representation because you need a certain amount of temporary investments to trade equities.
2. Can't carve out an equity part (e.g. from a global fund) from Jan 2010 and just allocate cash. It has to be managed separately with it's own cash balance if you want to carve it out.
3. Before Jan 2010, you can carve out and ration/allocate your cash as long as you do it in a timely manner. Have to disclose how you allocate the cash and the % of the composite that is composed of carve outs.
4. Allocating cash to carve-outs 2 ways:
i. % of beg. portfolio market value (excluding cash e.g. 80/20 stocks/bonds)
ii. Strategic vs actual allocation to equities
35% to 37.5% strategic = 2.5% held in cash associated with the equity
5. Equity returns off the back of that just take the weights (beg. or strategic) and then multiply out by returns on the asset for that month

Front 21

Disclosures for GIPS

(SS18)

Back 21

Disclose:
1. All significant events, like if your best manager left
2. Description of all the firms composites (and discontinued ones closed in the past 5 years)
3. If you have been verified, the periods for which you are verified
4. Rate-of-return calculations
5. Benchmarks used
6. Currency used to express performance
7. Detail treatment of WHT
8. If you are using indices that are net-of-taxes
9. Say "Further info on how calcs are performed is available on request"
10. Fees; are the returns gross of fees (after trading expenses), or net of fees (after trading AND management fees)
11. Description of that particular composite
12. Disclose composite creation date
13. Disclose the dispersion measure that you're using
14. An explanation of what a derivative/leverage is (if you have them)
15. Policy used to allocate cash to carve outs
16. Disclose minimum asset level for a pf to be added to the composite
17. Disclose if you're using local laws and explain how they differ to GIPS
18. Define rebalancing rules (monthly, quarterly)

Front 22

Measures of dispersion


(SS18)

Back 22

1. Measures of dispersion
High/Low
Good: Easy to understand
Bad: Outliers abnormally high or low returns, doesn't show good distribution of returns.
2. Interquartile range
Good: Not skewed by outliers, shows you the 50% range
Bad: Clients have never heard of it
3. Standard deviation
Good: Most people have heard of it
+_ one sd contains 67% of results
Also good because it's a valid measure.
OK to show returns for a non-calendar fiscal year
NOT ok to annualize returns

Front 23

Portability of returns
Can you take your old composites to a new firm?

(SS18)

Back 23

If 3 conditions are met
1. All your decision makers work for you
2. Staff and decision-making rules are still in tact at the new place
3. Records that support the old reported performance are allowed to come with you

Front 24

Real estate and in composites?

(SS18)

Back 24

GIPS gives special rules for some real estates securities
1. Real estate should show total return and then split it down into income and capital appreciation
2. Real estate is not
REITS
anything listed (e.g. Simon Prop.)
MBS's
commercial and residential loans (because they are ir based)
3. Real estate special GIPS is:
Anything with participation
unlisted REITS
4. Real estate has to be valued at market value at least every 12 months. From Jan 2008 at least quarterly
5. Real estate valued by an external consultant every 36 months
6. Disclose how and how often you value your real estate
7. Think about if a real estate pf you have is non-discretionary if the client stops you from selling a property (where they want to wait for a rebound, or not take the capital gain)
8. Capital return
MV₁ - MV₀ - Capital exp. + Sales
------------------------------------------------
Capital Employed
9. Income Return =
Income - Non-recoverable exp. - Interest - Tax
-------------------------------------------------------------------
Capital Employed
10. Single period return total return = capital + income return
11. Multi period return CHAIN LINK the total return
12. GIPS recommends annualizing the SI-IRR (since-inception rate of return) with CFs for no longer than an individual quarter.

Front 25

Private equity in composites?

(SS18)

Back 25

Venture Capital
1. Venture capital to also show total COMMITTED capital (any extra that you have said you are going to pour into the venture in the future)
2. Venture capital with special GIPS is not for the tradable:
Evergreen funds
Open-ended funds
Venture capital GIPS IS for
Closed-end funds
3. Composite for VC defined by strategy and vintage year. Put open-end VC funds in a DIFFERENT composite to closed-ends.
4. VC valued by experienced people according to documented procedures at least annually (though quarterly is recommended)
6. Valued on a fair value basis (i.e. a current transaction between willing, knowledgeable parties)
7. Best way to value VC
i. Market based transaction
ii. Then, market based multiples like P/E of similar public co. with a discount for loss of marketability.
iii. Least fav. way of doing it because it relies on too many assumptions is PV of risk-adjusted expected CFs.
8. GIPS says must show Net-of-fees (shown after carried interest is paid to the general partners of the venture receive) and Gross-of-fees annualized SI-IRR
9. TVPI = Total value of paid in capital
DPI = Distributions to paid in capital
PIC = Ratio of Paid in capital to committed capital (how much left have they said that they will contribute.

Front 26

Verification

(SS18)

Back 26

Verification Disadvantage:
i. Costly and time consuming
Advantage
i. Marketing advantage
ii. Firms end up improving their internal controls/ operations.
1. Check accounts to see if they are properly treated as discretionary or non-discretionary
2. # of composites at firm
3. # of portfolios in each composite
4. Check internal controls
5. Check computer applications
6. Check that new accounts/ terminated accounts follow the firms internal documented policies
7. Check dispersion measures


NOT compulsory to be verified (just encouraged)
NO single composite can be verified. Verification is at the firm level.
NO verification periods less than 1 year
NO except for's

Front 27

GIPS Advertising Guidelines

(SS18)

Back 27

1. Advertisements are anything that is any written or electronic material addressed to more than one prospective or existing client
2. Anything to retain clients or solicit new ones.
3. "FIRM X has prepared and presented this report in compliance with the GIPS"

NOT single client communication
OK if more than one person is in attendance at a single client communication.
OK to show no benchmark in your advertisement, but you have to say why. Otherwise always include a benchmark.

Front 28

Other GIPS issues
After Tax Reporting

(SS18)

Back 28

After-tax reporting is problematic
1. GIPS only gives guidance
2. Preliquidation takes into account only taxes realised during measurement period. Doesn't think about the tax liability of the unrealised if sold, just the actuals.
Preliquidation = Assumes unrealised CG are untaxed.
3. Mark-to-liquidation = assumes unrealised CG ARE all taxed in that period. This overstates the tax effect
4. You can have different tax rates for the same asset in different jurisdictions (NYS, NYC, US vs Australia)
5. Different rates for different income, ordinary, Short term CGT, Long term CGT
6. After tax benchmarks also need to incorporate the client's tax status (in addition to all the other benchmark validity measures)
7. Good after tax benchmarks
Regular ETFs
Bad after tax benchmarks
Index ETFs
Mutual Funds (because of deposit/redemptions of shareholders)