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The Global Investment Performance Standards (“GIPS®”) are a set of voluntary, ethical standards developed by CFA Institute in partnership with other organizations worldwide. The creation of the GIPS standards was spurred by a need for prospective investors to be able to make meaningful comparisons of investment performance across multiple managers, for any given strategy. As acceptance of the GIPS standards continues to spread globally, adoption remains especially strong in the United States. Managers that are registered with the U.S. Securities and Exchange Commission (“SEC”) as investment advisers under the Investment Advisers Act of 1940 (“Advisers Act”) and that claim compliance with the GIPS standards have an obligation to comply with the requirements set forth by both the SEC and CFA Institute.
While there are many similarities between the rules under the Advisers Act and the requirements of the GIPS standards, there are some notable differences. Our experience working with compliance professionals gives us an understanding of the challenges of navigating both frameworks. This article will compare and contrast the key differences between the Advisers Act and the GIPS standards relating to the presentation of investment performance.
Ultimately, the mission of both bodies is to ensure investors are not misled and are provided with full and fair information with respect to their current and/or future investments. This article does not attempt to identify every difference between the Advisers Act and the GIPS standards.
Rule 206(4)-1 under the Advisers Act prohibits certain types of advertisements, including any advertisement that contains any untrue statement of material fact, or that is otherwise false or misleading. Additionally, the Advisers Act’s broad anti-fraud provisions apply to all written correspondence, so even items that are not technically within the definition of an “advertisement” must not contain false or misleading statements. Rule 206(4)-1 generally defines an “advertisement” to include any written communication addressed to more than one person, and any notice or announcement in a publication or on radio or television, which offers or solicits any investment advisory service.
The SEC’s guidance around advertising focuses largely on disclosures necessary to cause the advertising to not be deemed false and misleading. In addition, the requirements apply equally to information provided to prospects and clients. In contrast, if an adviser claims compliance with the GIPS standards, it must provide all prospective clients with a GIPS compliant presentation (“GIPS CP”).
Unlike the GIPS standards, the SEC has not adopted any specific rules around the use of composite performance in advertising and marketing materials. However, changing composite inclusion criteria may indicate to the SEC that the adviser is “cherry picking” to show better performance results. Therefore, although not expressly required by rule, SEC examiners may be interested in reviewing the controls an adviser implements around composite maintenance.
Prospective and Existing Client Communications
While both the SEC advertising rules and related staff letters and the GIPS standards cover communications made to prospective investors, the SEC requirements additionally address communications made to existing clients, such as client reports. This is because the SEC essentially views materials sent to current clients as marketing that is designed to help the adviser retain those clients. In contrast, the GIPS standards are focused only on information presented to prospective clients. This represents a key distinction between GIPS and SEC requirements.
Rule 206(4)-1(a)(5) prohibits any misleading advertisement. Even entirely factual advertisements can be prohibited if the overall effect of the advertisement is misleading, such as when an adviser fails to disclose that current period performance is running significantly less than the prior year performance being reported or that performance returns earned in the prior period were significantly impacted by investments in IPOs that is not sustainable in the current period. When considering whether an advertisement is misleading, an investment adviser must use good judgment and should consider any applicable factors, including: (i) the presence or absence of explanations and disclosures, including any material facts regarding the adviser, its personnel and investment strategies, relevant market and economic conditions, and the types of assets in which its clients invest; (ii) the prominence of disclosures; (iii) whether information is current, particularly with respect to performance advertisements; (iv) whether descriptions of potential gains are balanced by disclosures of risks and the potential for loss; (v) implications that past performance will be sustained in the future; (vi) any exaggerated or unsubstantiated claims, or the use of superlatives; and (vii) the advertisement’s overall context and the sophistication of the recipients.
Rule 206(4)-1 falls under Advisers Act anti-fraud provision (Section 206) and is effectively a catchall that prohibits misrepresentations, omissions of material facts, false or misleading statements, and testimonials; limits use of past specific recommendations and restricts use of graphs and charts that represent in any way that the graph or chart by itself can be used to determine which securities to buy or sell, or when to buy or sell them; or suggests that any graph, chart, formula or other device being offered will assist any person in making his own decisions as to which securities to buy, sell, or when to buy or sell them, without prominently disclosing the limitations and the difficulties of those devices when a client is using them.
Unlike the GIPS standards, which provide a comprehensive set of rules and requirements around the presentation of performance in adviser advertising/marketing materials, the SEC’s staff has issued guidance regarding the content of performance advertisements through SEC staff letters, administrative proceedings, and interpretive releases since 1979 that expand and clarify the limited explicit guidance provided in the rule itself. The key no-action letters include Investment Counsel Association of America: Advertisement definition; Clover Capital Management, Inc.: Prohibited advertisements; Investment Company Institute (“ICI”) II: One-on-one presentation of performance; J.P. Morgan Investment Management, Inc.: Advertise composite performance using model fees if equal to highest fee charged; Horizon Asset Management: Portability of performance (includes predecessor performance); Cambiar Investments, Inc.: Partial client lists; and Franklin Management, Inc. and The TCW Group, Inc.: Past specific recommendations (client letters, representative accounts, best and worst performing holdings).
The SEC and the GIPS standards approach the concept of investment discretion differently. The SEC views a firm as having discretionary authority, or managing assets on a discretionary basis, if it has the authority to decide which securities to purchase and sell for the client or if it has the authority to decide which investment advisers to retain on behalf of the client. If the adviser is required to obtain the client’s approval to implement an investment decision, then the adviser does not have discretion over the client’s account.
From a GIPS standpoint, the term discretion refers to the ability of the firm to fully implement its intended investment strategy. While this allows for some flexibility when determining which portfolios are discretionary or not, firms must define discretion and apply this definition to all accounts consistently (it should be noted that discretion can be defined on a composite-by-composite basis). Firms often will have client-imposed restrictions placed on an account, but not all of these restrictions would automatically cause a portfolio to be considered non-discretionary. For example, if a client places a restriction on the purchase of “sin” stocks (stocks of companies associated with activities that may be considered unethical or immoral), and the inability to purchase sin stocks does not interfere with the portfolio manager’s implementation of its investment strategy, then the portfolio would be considered a discretionary account. However, if these holdings were material investments in the strategy, the account would be considered non-discretionary. The differences in the meaning of discretion from a GIPS and SEC perspective may result in accounts that are considered discretionary from an SEC viewpoint being considered non-discretionary from a GIPS standpoint.
Net vs. Gross Returns
The SEC generally requires that advisers present their returns net-of-fees. Since 1986, the SEC’s Division of Investment Management has issued several letters that qualified the requirement that performance be presented net-of-fees when advisers choose to show performance results in advertisements, as stipulated in the letter issued to Clover Capital Management. In a second SEC staff letter issued to the Investment Company Institute on September 23, 1988 (often referred to as “ICI II”), the Division of Investment Management permitted the use of performance figures that were gross of advisory fees in “one-on-one” presentations, when the presentation is private in nature and the prospective client(s) have ample opportunity to ask questions and discuss fee arrangements. The SEC permits an adviser to show both gross-of-fees and net-of-fees performance provided these presentations have equal prominence and include all necessary disclosures to make the presentation not misleading.
When comparing performance across multiple firms, the GIPS standards recommend that investment managers present gross-of-fees performance because it generally serves as a universal point of comparison and provides the truest picture of the firm’s expertise. This is due to the fact that net-of-fee returns can be distorted by the impact of fee negotiations.
There is, however, some flexibility. Firms may present either gross-of-fee or net-of-fee returns in the GIPS CP. Additionally, the GIPS standards require that firms must comply with any applicable laws and regulations regarding the calculation and presentation of performance. Therefore, investment advisers in the US generally include both gross and net returns in the GIPS CP to ensure all that regulatory requirements are met.
Timeliness of Returns
The GIPS CP must, at a minimum, include annual returns for a composite and must be updated on an annual basis. Some firms opt to update the returns more frequently, but it is not required.
The SEC does not require an adviser to include performance results in its advertising/marketing materials. However, if an adviser chooses to include performance information, the SEC generally requires the adviser to update the performance information at least quarterly to ensure that it has not become stale, as stale performance information could be deemed false and misleading. To satisfy both sets of requirements, many firms update their performance presented in the GIPS CP on an annual basis and include more current returns elsewhere in the firm’s marketing materials.
Composite vs Account/Fund Returns
GIPS-compliant firms are required to make every reasonable effort to provide a GIPS CP to all prospective clients. Additionally, ongoing prospective clients must receive the GIPS CP at least once every twelve months. Once a prospective client becomes a client, or is no longer considered a prospect, firms no longer have an obligation to provide them with the GIPS CP. The presentation of composite performance is the primary vehicle by which strategy returns are presented to prospective clients under the GIPS standards. Composites are defined according to a particular investment mandate, objective, or strategy and must include all actual, fee-paying portfolios managed to each respective strategy. This requirement prevents firms from having the ability to cherry pick their best performing portfolios to present to prospective clients.
The GIPS standards also allow for the presentation of additional and/or supplemental information in addition to the composite results as long as the information is not considered misleading. For example, a firm may present representative account information for a particular investment strategy. The key is that the firm has a process in place to ensure that consistent criteria are utilized for selecting the representative account and the criteria is non-performance based. From a SEC perspective, firms could show the performance of a representative account. While this is not preferred, it is allowable and the SEC requires that there be selection criteria to determine that the representative account is objective (e.g., not cherry picked) and that the appropriate disclosures are made to ensure the presentation is not misleading. Key concerns in selecting a representative account, rather than showing the performance of the entire composite, are consistency of investment strategy, investment restrictions, fee structure, time frame managed, type of client, and size of account, among others.
AUM/Total Firm Assets
The GIPS standards define total firm assets as the aggregate of the fair value of all discretionary and non-discretionary assets managed by the firm. This includes both fee-paying and non-fee-paying portfolios. Total firm assets must also include any assets managed outside the firm provided that the firm has the authority to allocate assets across sub-advisers. Advisory-only assets must not be included in the GIPS total firm assets figure. Advisory-only assets are assets for which the firm has no control over whether investment recommendations are accepted, or for which the firm does not have trading authority. Total firm assets must also be presented net of any leverage employed in accounts.
By SEC definition, for an adviser to claim that assets are managed on a non-discretionary basis, the adviser must execute the trades once the client approves the adviser’s investment recommendation. If the adviser is not responsible for executing the transactions, the adviser cannot include those assets in its Regulatory Assets under Management (“RAUM”). The SEC defines RAUM as the current market value of securities portfolios for which the adviser provides continuous and regular supervisory or management services over discretionary and non-discretionary assets. In addition, the SEC defines RAUM as gross assets, which means it cannot deduct indebtedness/liabilities in this calculation.
GIPS-compliant firms have a responsibility to capture and maintain all data and information necessary to support all items included in a GIPS CP. There is not a precise list of required documents that must be maintained. Therefore, it is up to the firm to evaluate and determine its own situation as it relates to meeting the recordkeeping requirements. The Guidance Statement on Recordkeeping Requirements offers guiding principles to assist firms in understanding what must be maintained. Aside from the requirement to comply with all applicable laws and regulations regarding the calculation and presentation of performance, the guiding principles require that firms maintain sufficient records that allow for the recalculation of portfolio-level returns, composite-level returns, and other composite–level data. Additionally, firms must maintain records to support why a portfolio was assigned to a specific composite or was excluded from all composites. Aside from the performance considerations of the recordkeeping requirements, firms must also maintain records, as well as all policies and procedures, to support their claim of compliance on a firm-wide basis. A significant departure from regulatory requirements in the US is that the GIPS standards require that all records deemed necessary by the firm must be maintained for each year they are presented in a GIPS CP. Therefore, if a firm is presenting a rolling ten years of annual returns, when a year drops off of the GIPS CP and the most recent year is added, the firm is no longer required to maintain the supporting records for the year that was removed.
According to SEC requirements, investment advisers must retain all documentation that substantiates all performance that is currently being advertised or has been advertised for the past five (5) years. This includes all accounts, books, internal working papers, and any other records or documents that form the basis for or demonstrate the calculation of the performance or rate of return of any or all performance included in any advertising or marketing materials. Most importantly, however, unlike the requirements of the GIPS standards, the SEC requires that documentation be retained for at least five (5) years after an adviser stops advertising the relevant performance, as opposed to the GIPS standard of no longer being required to maintain the documentation once the time period is no longer included in the presentation.
The GIPS standards require compliant firms to establish policies and procedures to deal with the correction of errors found in a GIPS CP. The scope of the error correction policy is limited to the GIPS CP, however many firms use the same principle for errors discovered in all marketing materials and advertisements. Errors in the GIPS CP are not limited to performance errors. The GIPS standards define an error as any component of a GIPS CP that is missing or inaccurate. In addition to composite and benchmark performance, this includes statistics such as composite assets, firm assets, number of portfolios in a composite, measures of internal dispersion, three-year annualized ex-post standard deviation and disclosures.
A firm’s error correction policy must include a definition of materiality and should incorporate the course of action a firm will take given the degree of the error that is identified. There are a number of ways a firm may go about correcting an immaterial error. However the GIPS standards do require that certain measures be taken in the event a material error is discovered. Material errors must be corrected and disclosed in the corrected GIPS CP. Additionally, a disclosure of the change in the updated GIPS CP must be included for a minimum of twelve months following the correction. The corrected GIPS CP must be given to all existing clients who received the inaccurate one and every reasonable effort must be made by the firm to provide the corrected GIPS CP to all prospective clients and third parties who received the erroneous presentation. Firms are not required to provide the corrected presentation to former prospective clients provided that the firm has procedures in place to determine when a prospective client is no longer a prospect for a given composite strategy.
The SEC has no formal requirements regarding error correction. The SEC relies on the standard that performance presentations cannot be deemed false and misleading nor have any material facts omitted. If a presentation contains information that is deemed to be false and misleading, the adviser is obligated to timely correct the information upon learning of the inaccuracy and provide the corrected performance information, including necessary disclosures that explain the restatement, to all clients and prospective clients who previously received the incorrect information under the premise that the client or prospective client may have used that information in its decision to invest with the investment adviser or retain that investment adviser.
While the general principal on portability is the same between GIPS requirements and the SEC, this is an area where the GIPS standards may, in some ways, be viewed as being more stringent in its requirements. The GIPS standards require that the performance of a past firm or affiliation must be linked to or used to represent the historical performance of a new or acquiring firm if, on a composite-specific basis, all of the portability requirements are met.
The GIPS standards provide three elements of portability that must be met to port a track record from the past firm to the new one: (i) substantially all of the investment decision makers must be employed by the new or acquiring firm; (ii) the decision-making process must remain substantially intact and independent within the new or acquiring firm; and (iii) the new or acquiring firm must have the records that document and support the performance.
Unlike the GIPS standards, the SEC permits, but does not require, investment advisers to advertise performance figures achieved by an employee or team while managing assets at another firm. However, in order for an adviser to advertise such returns, the adviser must ensure that: (i) no other person or team played a significant role in generating the performance at the prior firm; (ii) the accounts under management at the predecessor adviser are sufficiently similar to the accounts currently managed by the employee or team to provide a relevant comparison; (iii) the performance of all accounts previously managed by the employee or team are incorporated in the advertisement, unless the exclusion of one or more accounts does not result in materially higher performance; (iv) the advertisement includes all necessary disclosures, including a disclosure that the results were achieved by an employee or team at a different firm; and (v) the adviser maintains documentation necessary to substantiate the performance that was achieved while the employee or team was working for the other adviser.
In many cases, the last requirement is where firms face most challenges in porting performance from one firm to another. This is especially the case when a team’s departure from the prior firm is not amicable. Since the firm must present the track record of the entire composite, firms are required to obtain and be able to support the performance of each underlying account in the composite for the full history.
In addition to the noted differences included above, there are a number of other disclosure requirements that differ between the GIPS and the SEC performance standards. Compliance with the Advisers Act does not ensure compliance with the GIPS standards, and vice versa. Since the GIPS standards are global in nature, it is important for firms to understand all of the differences between the requirements of the GIPS standards and local laws and regulations. While this is not an easy task, having specialized knowledge in-house or through third party consultants can be an effective way for US advisers claiming to be GIPS compliant to mitigate the risks associated with failing to comply with the requirements of both the GIPS standards and the SEC performance advertising standards.