GIPS 2010: An Evolution of a Standard

by William Mirrer
J.P. Morgan Investment Analytics & Consulting
william.x.mirrer@jpmchase.com

The Global Investment Performance Standards, or GIPS, serve as guidelines to assure clients that their investment management firms are calculating and presenting their performance on a consistent fair basis with full disclosure. GIPS provide an ethical foundation and self-regulated means to communicate performance figures to prospective and current clients. They are designed to provide investors with adequate performance information to ensure that stable investment decisions are made. The current version of GIPS was published in February 2005 and became effective on January 1, 2006. The GIPS executive committee reviews the standards every five years, ensuring that progress is maintained and that GIPS remain the global gold standard for performance. The purpose behind the changes is to develop new standards as well as calibrate existing ones.

In our dynamic economy, it is crucial for these guidelines to evolve and adapt. Given that financial complexity is increasing, performance standards must accordingly adapt to maintain integrity and accuracy. Recent scandals from Bernard Madoff and Stanford Financial have triggered a series of events asking the same question - How can such fraud be exposed before the fact? Although GIPS were not designed to detect fraud and mischievous activity, they do provide a solid foundation for self-regulation and ethical behavior. The guidelines that GIPS provide can lay the path to detecting such fraud through erroneous reporting and outlier data. The modification of the standards has taken the form of heightened due diligence and transparency in financial reporting. In our view, GIPS have constantly evolved to maintain the reigns in a sector that has large potential for disarray and uncertainty.

The proposed adoption of the revised GIPS Handbook is planned for early 2010 with an effective date of January 1, 2011. As the GIPS executive committee begins to review the public's comments on the revisions, there are many interesting topics that are coming to light. Given the current environment, a majority of the changes are being centered on stricter risk reporting, accuracy, and timeliness. As the more prominent changes are implemented, it will be interesting to see the impact on pension plans and other institutional investors.

Proposed Revisions to GIPS

The more prominent adjustments that are being proposed to the GIPS 2005 Handbook are as follows:

Market Value to Fair Value Valuations - The move from market value to fair value is being implemented to ensure that performance figures are being calculated more accurately with increased transparency. This is being implemented during a time when investors are looking for more visible means to actively know the true value of their investments. Fair value is defined by GIPS as the amount an asset could be exchanged in a current arms-length transaction between willing parties prudently and without compulsion. Firms will now be required to document their policies, procedures, and methodologies concerning fair value. In addition to stricter documentation, firms will be required to follow a set hierarchy in how fair value is accounted for. The hierarchy for fair value is based off of quoted market prices for similar investments and market-based inputs other than quoted prices. This provides clients who are invested in opaque asset classes to have a better idea of the pricing and value of their investments. The new standard also adds a recommendation to persuade compliant firms to receive their fair values from an external third party. This ensures that managers do not use information that directly benefits their performance and reassures that the values are from a reliable source. The implementation of this standard is derived from and is more consistent with the International Accounting Standards and Financial Accounting Standards Board (FASB).

Risk Disclosure - The proposed GIPS requirements include several alterations related to risk disclosure. The definition of a GIPS composite will now incorporate additional risk standards and provide clients with more in-depth detail of the risks that are being taken per each composite's strategy. While the previous standards addressed the issue of the extent of leverage obtained and the use of derivatives per composite, GIPS 2010 incorporates the mandatory documentation of the use of short positions in each composite as well. In addition, full GIPS compliance will require firms to disclose the three-year annualized standard deviation for their respective composites and benchmarks. This will provide clients with the ability to better assess their manager's volatility in comparison with their respective benchmarks. The standards also clearly state that the periodicity of the measurement period (with a minimum monthly period) must be identical between the composite and its respective benchmark. This detail provides more insight for clients to compare different firm level and composite strategies and determine the amount of volatility taken by both the benchmark and portfolio.

Real Estate - Although the current GIPS recommendations concerning real estate are evolving into requirements for 2010, there will be a multitude of changes in terms of the effectiveness of the standard. The main alterations are on third party valuation techniques as well as timing. Instead of the previous 36-month verification, the standards will now state that all real estate holdings (excluding REITS, CMBS, and private debt holdings) are required to be valued every 12 months by an external appraiser (effective January 1, 2012). In terms of internal valuations, fair values must be adjusted on a quarterly basis, instead of the previous 12 months. This reassures that values are as timely and transparent as possible. Concerning closed ended real estate funds, the requirements for calculation methodology are now more defined. The standards will be more in line with private equity requirements and will recommend an annualized since inception internal rate of return (SI-IRR) for each year since composite inception.

GIPS Verification - The new standards will incorporate a mandatory guideline adjustment that makes firms disclose the exact date being verified and to clarify if they are currently compliant. Firms that are stating that they are currently verified would now be required to have documentation of verification within the last 24 months by an external third party verifier. This provides a more concrete standard to ensure that firms are presently verified and are not relying on outdated results. The standard clearly states that all GIPS compliant firms must be verified by qualified independent third party verifiers. The documentation also gives verifiers the option to rely on the previous work of another firm's previous appraisal and rely upon previous findings to complete their verification. Although this may seem more beneficial to verifiers, it may create problems if past firms have made mistakes that were not caught. For full disclosure, GIPS clearly states that if a previous firm's verification process is being used in conjunction with new found verification, the verifier must clearly state the time period used, testing results, qualifications, and reputation of the aforementioned verifiers process and findings.

Non-Fee Paying Portfolios & Proprietary Assets - This change focuses on requiring non-fee paying portfolios to be included in a composite. While prior standards gave firms the ability to choose whether or not the respective accounts were to be included in a composite if they were non fee paying, this update will tighten the margin and require it. Although the requirement is still based off whether or not the account is discretionary, the committee feels that if the manager has control of the assets the account must be included in a composite. Proprietary assets, or any asset owned by the firm, the firm's management, or the firms parent company must be displayed as a percentage of their respective composites assets. This enables the client to see the amount of "seed money" that is invested in the fund from the respective company. Although a small detail, it provides the client with the ability to show the amount of confidence the manager is truly showing in the fund, through the means of the manager's asset allocation to the fund.

Conclusion

In our view, the additions and alterations seem to be moving in a more beneficial environment for clients. For instance, the move to fair value stands out as being a prominent addition to illiquid investments, such as private equity and real estate valuations. It makes sense to take an opaque asset class such as alternatives and provide clarity. Although there has been much discussion pertaining to the treatment of such investments, one may wonder what impact this would have had prior to the current recession.

Making standard deviation mandatory in GIPS compliance seems like a step in the right direction toward incorporating risk more fully, but perhaps other measures could provide additional insight? For example, incorporating downside deviation and shortfall risk would provide investors with more information to assist them in judging their risk tolerance. Providing a deeper level of risk reporting would provide investors with a more fluent understanding of the risk the managers have taken. While GIPS are centered on performance, it would only seem fit, given the concerns of institutional investors globally, to amend the changes to more fully reflect performance on a risk-adjusted basis .

That said, GIPS 2010, if adopted, is certainly further progress in helping institutions make more informed investment decisions. In our view, GIPS may not be the saving grace to the industry's troubles, but they may be the right path to a sound conscientious future.