GIPS Changes Arrive in January 2011

As the investment management industry continues to expand both domestically and internationally, accurate and reliable financial data with high transparency and comparability is absolutely necessary for more effective and efficient investment decision making.

The Global Investment Performance System (GIPS) was established by the Chartered Financial Analyst Institute in 1999. The system is a set of ethical standards utilized by investment managers to calculate and report their investment results to investors. Since the inauguration of GIPS, these standards have gained in popularity and been adopted in nearly 30 countries. The first major revisions to the system occurred in 2005. The 2010 edition of GIPS, the second major set of revisions, becomes effective Jan. 1, 2011.

The newest revisions are meant to strengthen the transparency, consistency and comparability elements of the GIPS standards. The changes will affect guidelines for:

• Frequency of investment valuations
• Carve-out performance requirements
• Disclosure on investment risk and benchmarks
• Disclosure on net returns calculation
• Disclosure on probability tests
• Real estate and private equity investment provisions
• Provisions on providing GIPS compliant data to prospective investors

The most significant changes for periods beginning Jan. 1, 2010, are that firms must value portfolios on the date of all large external cash flows, as well as of the calendar month-end or the last business day of the month. Composite returns must be calculated by asset weighting the individual portfolio returns at least monthly, and carve-out returns are not permitted to be included in single asset class composite returns, unless the carve-outs are managed separately with their own cash balances.

Firms must satisfy all requirements of the GIPS standards in order to declare compliance. Periodic internal compliance checks are encouraged and firms have the option to obtain independent verification by allowing a third party to test whether composite construction and policies and procedures are in compliance with GIPS. Being verified is not yet a requirement, but it is strongly recommended by the GIPS Executive Committee. Additionally, firms may have a specifically focused composite testing (performance examination) to provide additional assurance on a particular composite.

There are currently four chapters to the GIPS standards, which begin by presenting the provisions of GIPS, including requirements and recommendations to be compliant. Firms must comply with all requirements of the standards, including any updates, guidance statements, interpretations, questions and answers, and clarifications published by the CFA Institute and the GIPS Executive Committee, all of which are available on the GIPS Standards website (www.gipsstandards.org), as well as within GIPS handbooks.

Firms should also implement the recommendations as a best practice in the calculation and presentation of performance.

The GIPS system looks at nine distinct areas:

1. Fundamentals of compliance: The foundation of the GIPS standards is based on principles that include proper definition of the firm, the firm’s definition of discretion, providing compliant presentations to all prospective investors, adhering to applicable laws and regulations, and ensuring the accuracy of information presented.
2. Input data: Input data has to be reliable and consistent. All necessary supporting data must be captured and maintained. For periods beginning on or after Jan. 1, 2011, portfolios must be valued in accordance with the fair value definition and the GIPS Valuation Principles.
3. Calculation methodology: Specific calculation methodology use is required to allow consistency and comparability.
4. Composite construction: Constructing meaningful composite is based on the asset class, investment strategy and objective. A composite should only include actual assets managed by the firm and should also consist of a number of averaged portfolios that collectively represent a group of portfolios with similar investment characteristics.
5. Disclosure: Firms are required to disclose information regarding their performance and adopted policies. This information includes required disclosures for all firms and circumstance-specific disclosures. All firms must disclose claim of compliance to indicate compliance with the GIPS standards and whether they have or have not been verified.
6. Presentation and reporting: Investment performance presentations must incorporate information regarding composite construction, input data, returns calculation and disclosures as required by the GIPS standards.
7. Real estate: Supplemental requirements and recommendations are outlined for real estate investments. The section now includes new provisions for closed-end real estate funds, which will become effective in 2011.
8. Private equity: Supplemental requirements and recommendations are not outlined for private equity investments. The provisions apply to the calculation and presentation of private equity investments made by fixed life and fixed commitment private equity investment vehicles, including primary fund and funds of funds as well as for secondary funds.
9. Wrap fee/separately managed account (SMA) portfolios: Supplemental requirements and recommendations are outlined for all wrap fee/SMA portfolios where there are bundled fees and the wrap fee/SMA sponsor serves as an intermediary between the firm and the end user of the investment services.

GIPS requires firms to apply a fair value methodology following the requirements and recommendations outlined by the system. Fair value is defined by GIPS as the amount at which an investment could be exchanged in a current arm’s length transaction between willing parties in which the parties each act knowledgeably and prudently. The standards also recommend the use of valuation hierarchy to determine fair value. The revised standards were developed in line with recent fair value measurement provisions adopted by the International Accounting Standards Board and the Financial Accounting Standards Board.

Firms must also document and disclose their valuation policies, procedures and methodologies, and demonstrate consistent applications. The provisions in the 2010 revision will particularly impact firms that invest in illiquid or harder to value securities (such as real estate, private equity, distressed investments suffering from the recent economic crisis and other alternative investments). Firms are required to disclose the subjective unobservable inputs and valuation methodologies used to value the investments.

The system also sets out advertising guidelines for firms claiming compliance to the GIPS standards as well as the outlined best practice verification process. Verification must be performed by a qualified independent third party and include a two-part assessment as to whether the firm has:

Firms looking to find a meaningful comparison for reported investment results should continue to watch the evolution of GIPS and may want to consider their path to compliance, if not already in compliance. The global standard of investment performance reporting benefits investment managers, existing investors and prospective investors.

Jason Yau is a director in McGladrey’s Financial Services Group.