Reasons to be cheerful about new GIPS standards

This article was originally published in Arab Times

The recently released Global Investment Performance Standards (GIPS®) outline new standards for presenting investment performance to potential investors.  Mr. Raghu Mandagolathur, President of CFA Kuwait, discusses these standards and why an investment firm would want to implement them.

The asset management industry in the GCC is rapidly evolving.  It is currently home to more than 325 mutual funds with nearly $ 125 billion under management including managed accounts.  Kuwait has established itself as a key hub within the region, and is currently home to around 65 funds (or 20% of the total) with an estimated assets under management of $58 billion.  Kuwait also boasts the oldest stock exchange in the region, probably the third largest in terms of market capitalization. Consequently Kuwait continues to develop a vibrant and growing domestic and international investment community with the presence of nearly 100 investment companies.  

If Kuwait is to continue to attract the very best investors from both home and abroad, to evolve and grow its investment industry, we must promote high standards of performance measurement and presentation, to help promote better transparency, market integrity and fairness. The importance of setting standards in performance reporting has become paramount.   

But what standards should we use and how should they be introduced?  At CFA Kuwait we believe GIPS® provide a suitable framework to help raise standards of investment management in Kuwait and around the GCC.

What are the Global Investment Performance Standards (GIPS®)?

GIPS are voluntary ethical standards for the calculation and presentation of investment performance.  Their genesis dates back to the 1980s when unscrupulous investment managers presented their best-performing portfolios to prospective clients in hopes of winning their business. 

This performance was generally not representative of the firm’s overall investment results for that strategy.  The focus of the GIPS standards, therefore, is the presentation of performance to prospective clients who want reliable performance metrics based on the principles of fair representation and full disclosure. 

 

What areas do the GIPS standards cover?

The GIPS standards address such topics as input data, calculation methodologies, composite construction, performance presentation, and disclosures in both traditional and alternative asset classes.  The Standards are continually evolving to meet the needs of a dynamic industry.  Interpretations are developed and issued on an ongoing basis to assist firms in implementing and applying the Standards.

 

What is a composite?

A composite is an aggregation of portfolios managed in accordance with similar investment mandates, objectives, or strategies. All discretionary fee-paying portfolios must be included in at least one composite, and composite performance must be calculated and presented as the asset-weighted average of the performance of the portfolios within the composite.  Investors are thus presented with performance that is truly representative of a firm’s investment results for a particular strategy.

 

Do the standards apply to public equity funds and private equity funds in the same way?

Many provisions of the GIPS standards apply to both public and private equity investments.  However, the GIPS standards also include specific requirements and recommendations for private equity (as well as real estate).  Most private equity investments are made through limited partnerships in which the investment manager controls the timing of capital drawdowns and distributions.  The GIPS standards require the use of a different calculation methodology, the internal rate of return, that reflects the timing of those cash flows.

 

What is new in the 2010 edition of the GIPS standards?

The recently released 2010 edition of the GIPS standards introduces several important new concepts.  Firms will be required to value investments based on fair value rather than market value.  Although fair value and market value are often the same for liquid securities, liquidity may dry up at times and market values may not be available or reflective of the true value of the investment.  For investors, it is essential to know what their investments are actually worth. 

New provisions have also been added to address risk, including a requirement for firms to present the three-year standard deviation of composite and benchmark returns.  This is not the most sophisticated nor, for some strategies, the most appropriate measure, but it establishes a foundation for comparability.  The decision to include provisions related to risk is a clear statement that performance includes both risk and return and investors must evaluate both.

 

Do the GIPS standards prevent fraud?

Although the GIPS standards are not specifically designed to prevent fraud, the Standards require firms to present only the performance of actual assets under management and not hypothetical or model performance.  In addition to requiring firms to adhere to all applicable laws and regulations, the Standards prohibit the presentation of any performance information that is false and misleading.  The comprehensive policies and procedures required by the GIPS standards give investors additional comfort regarding a firm’s infrastructure and operational controls.

How do firms demonstrate compliance?

Firms can claim compliance once they have met all the requirements of the Standards and prepare a compliant performance presentation.  Firms can also have an independent verifier assess if the firm has complied with the composite construction requirements of the GIPS standards and if the firm’s policies and procedures are designed to calculate and present performance in compliance with the Standards.

 

Why should investment firms implement the GIPS standards?

Compliance with the GIPS standards signals to the marketplace that a firm is committed to integrity and enhances a firm’s credibility when competing for assets.  Because the GIPS standards are global, compliance provides firms with a passport to compete with other firms worldwide. In addition, firms that implement the Standards may strengthen internal controls and increase the consistency of their performance data.

An earlier version of this article appeared in the international edition of the Financial Times (FTfm supplement).  In addition to Mr. Mandagolathur’s comments,  Mr. Jonathan Boersma, executive director of the Global Investment Performance Standards at CFA Institute and Mr. Philip Lawton, CFA, CIPM, head of the CIPM program, also both contributed to this article.