Vol. 19, No. 11 • November 2012
GIPS Guidance Statement on Alternative
Investment Strategies and Structures – What
Alternatives Investment Managers Need to Know
By Michael S. Caccese and Douglas Y. Charton
O
n May 18, 2012, the CFA Institute’s GIPS Executive Committee,
governing body for the Global Investment Performance Standards
(GIPS® or GIPS Standards), formally adopted the “Guidance
Statement on Alternative Investment Strategies and Structures” (the
Guidance Statement), which became effective on October 1, 2012. The Guidance
Michael S. Caccese, a partner with K&L Gates
LLP, is one of the Practice Area Leaders of the
firm’s Financial Services Practice, which includes the
Investment Management and Broker-Dealer Practice
Groups. Mr. Caccese focuses his practice in the areas
of investment management, including mutual funds,
closed-end funds, private investment funds, hedge
funds, and managed accounts, in addition to advising on investment management and broker-dealer
regulatory compliance. He works extensively with
investment firms on compliance issues, including all
forms of GIPS and CFA Institute standards. He was
previously the General Counsel to the CFA Institute
and was responsible for overseeing the development
of the AIMR-PPS, GIPS, and other standards governing the investment management profession and
investment firms. He can be reached at 617.261.3133
and michael.caccese@klgates.com.
Douglas Y. Charton, an associate with K&L
Gates LLP, is a member of the firm’s Financial
Services Practice. Mr. Charton focuses his practice
on advising investment advisers, mutual funds,
closed-end funds, funds of hedge funds and separately managed account programs, in addition to
advising on investment management and securities regulatory compliance. He can be reached at
617.951.9192 and douglas.charton@klgates.com.
The authors would also like to acknowledge the
assistance of K&L Gates Associate Michael J. Rohr
for his contributions to this article.
© 2012 K&L Gates LLP. This article is for information purposes and does not contain or convey
legal advice. The information herein should not
be used or relied upon in regard to any particular
facts or circumstances without first consulting with
a lawyer.
advice or not, inclusion of the foreign fund’s
assets within the firm definition should be
based on the “substance over form” principle.
The Guidance Statement states that in the preceding situation, if the firm can demonstrate
that it effectively exercises discretionary investment management and can provide documented evidence that all investment advice has
been implemented accordingly, it must include
the foreign fund in the firm definition.3
Practice Note on Composite Construction – The
Guidance Statement introduces the “substance
over form” principle in the context of determining whether a portfolio must be included in the
firm definition (and counted towards total firm
assets), an apparent departure from previous
GIPS guidance that advisory-only relationships,
such as unified managed account platforms
(UMAs), where the adviser provides a model
or recommendations but has no control over
investment decisions or trading control, must
not be included in a firm’s total firm assets.4
In addition to total firm asset determinations,
the Guidance Statement also suggests that
the “substance over form” principle applies
to discretionary determinations as well. The
Questions & Answers section states that as
long as the firm effectively exercises discretionary management over the portfolio (that is, all
of its investment decisions are implemented),
the portfolio should be included in the firm’s
total firm assets and, presumably, in at least
one of the firm’s composites as a discretionary
portfolio. We believe the same approach would
be appropriate in any advisory-only situation
where a third party retains final decision-making
authority and is theoretically free to follow the
firm’s advice or not (for example, any subadvised account, portfolios over which a client
retains approval or veto rights over investment
decisions, UMAs, separately managed account
platforms (SMAs), etc.).
In addition, the Questions & Answers scenario provides that the firm should be able to
demonstrate that it effectively exercises discretionary investment management and can provide documented evidence that all investment
advice has been implemented accordingly.
Firms could interpret this position to suggest
an approach that a portfolio subject to third
party oversight is discretionary provided that
its performance for the period reflects the
Statement is primarily intended to address
difficulties that arise in applying the GIPS
Standards to non-traditional asset classes;
however, firms that claim compliance with
the GIPS Standards must comply with the
new guidance for all of the firm’s composites
regardless of the asset classes the firm manages.
The Guidance Statement includes guidance
on the following topics:
•
•
•
•
Firm Definition;
Composite Construction;
Input Data;
Valuation (methodology, frequency and
estimated valuation);
• Performance Calculation (fees and expenses for fund of funds and master-feeder
structures);
• Side-pockets (composite construction
and performance); and
• Disclosure (risks and benchmarks).
This article summarizes the key guidance
principles contained in the Guidance Statement
with a view towards the practical implications
that such principles will have on the practices
of GIPS-compliant firms, particularly in light
of Securities and Exchange Commission (the
SEC) and Financial Industry Regulatory
Authority (FINRA)1 performance presentation
and advertising rules and requirements.2
Firm Definition
The Guidance Statement advises that in situations where it may be difficult to assess whether
a particular portfolio should be included in the
definition of the firm (for example, where a
firm manages alternative investment portfolios
or other portfolios that involve complex legal
arrangements), firms must apply a “substance
over form” principle, as it would be inappropriate and against the ethical spirit of the GIPS
Standards to make use of formal legal structures to avoid inclusion of certain portfolios or
assets in the definition of the firm.
The Questions & Answers section of the
Guidance Statement also provides that where
a firm acts as an investment sub-adviser to a
foreign fund that is managed by a third party
who is theoretically free to follow the firm’s
THE INVESTMENT LAWYER
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based on the strategy that the firm has been
hired to manage. If the firm has been hired
to manage the entire LDI strategy (including both fixed income and the swap overlay),
the entire portfolio must be included in the
composite. If the firm has been hired as a
fixed income manager but implements a swap
overlay strategy according to client instructions, the firm may treat the overlay portion of
the strategy as non-discretionary and exclude
it from the composite. This is similar to how
GIPS treats overlay strategies in a Multiple
Strategy Portfolio (MSP) or similar program.6
Consistent with the GIPS Standards, the
Guidance Statement reminds firms that all
of a firm’s actual, fee-paying discretionary
portfolios must be included in at least one
composite.
Practice Note on Composite Definition GIPS Standard 3.A.4 requires that a composite include all portfolios that meet the composite definition. Where the firm groups alternative vehicles into new composites or creates
single-portfolio composites, the firm must take
great care in defining composites. Defining a
composite broadly may result in the inclusion
of portfolios that may be managed differently,
while a narrow definition may constrain strategy flexibility and/or exclude portfolios that
may actually belong in the same composite.
Practice Note on Related Performance –
The GIPS requirement that composite performance include all portfolios that meet the
composite definition is consistent with the
SEC’s approach, which permits related performance to be presented in adviser materials
provided that it is accompanied by sufficient
disclosures.7 In contrast, FINRA prohibits
presenting related performance in brokerdealer material unless the broker is presenting
to qualified purchasers marketing material for
a fund that relies on the Section 3(c)(7) exemption from registration under the Investment
Company Act of 1940.8 By their nature, GIPScompliant composite presentations will usually constitute related performance.
performance that would have been obtained
had the firm been free from the third party
oversight (for example, where any recommendations not implemented are immaterial to the
portfolio’s and/or composite’s performance).
Finally, even if the GIPS Standards permit
a firm to include a portfolio that is subject
to third party oversight in a composite, the
SEC could deem such inclusion misleading
if the firm fails to disclose that the portfolio
is subject to a third party’s oversight and/or
final authority because such oversight may
impact the way the portfolio is managed even
if the third party actually implemented all of
the firm’s investment advice. Firms should
consider whether such disclosure should be
included in a GIPS-compliant presentation.
Strategies With Unique Defining
Characteristics
The customization of alternative strategy
portfolios can often present difficulties with
respect to composite membership and assignment. The Guidance Statement advises that
when constructing composites for alternative
strategies, a firm should assess: (1) whether an
alternative investment vehicle may be included
in an existing composite; (2) whether it can be
grouped with other alternative (or traditional)
vehicles for a new composite; or (3) whether a
separate single-portfolio composite (such as a
single-fund composite) should be created. The
firm should consider the following factors,
among others, when constructing alternatives
composites:
• Investment mandate, objective, or
strategy;
• Concentration and/or degree of
diversification;
• Leverage; and
• Risk objectives.
In addition, the Questions & Answers section of the Guidance Statement provides a
composite construction example relating to
Liability Driven Investment (LDI) strategies
for pension fund clients, particularly in the
case of an actively managed bond portfolio
with a swaps overlay.5 The Guidance Statement
advises that composite construction should be
Inclusion of Hypothetical
Back-Tested Performance
Firms are permitted under the GIPS
Standards to present simulated, model or
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Vol. 19, No. 11 • November 2012
returns that included hypothetical back-tested
performance data. Based on this enforcement
action, broker-dealers should independently
verify whether an index/benchmark includes
hypothetical back-tested performance (based
on the inception date of the index and the
dates for which the index includes performance
history). If the index includes hypothetical
back-tested performance, the firm must disclose this fact and must identify the source
of the hypothetical back-tested performance
history. Also the firm must disclose sufficient
information about the similarities and differences between the fund and any indices/
benchmarks used to provide the reader with
a sound basis for evaluating the facts with
respect to the product.13
hypothetical back-tested performance as
supplemental information. The Guidance
Statement advises firms that where a fund or
portfolio includes derivatives/leverage, presenting performance of only the “unleveraged” portion of the portfolio is considered
to be hypothetical performance.9 Performance
of only the unleveraged portion must not be
included in a composite (that is, the entire
portfolio must be included) but may be presented as supplemental information, consistent with the GIPS Guidance Statement
on the Use of Supplemental Information as
well as with applicable rules and regulations
(see Practice Note below). Alternatively, if
the use of derivatives is non-discretionary, the
non-discretionary derivatives positions can be
removed from the portfolio entirely and their
contribution to return excluded.
Practice Note on Model or Hypothetical
Back-Tested Performance – Performance
presentation and advertising must also comply with applicable SEC and FINRA rules and
guidance.
Model Performance – The SEC permits
investment advisers to include model performance but requires that it be accompanied by
sufficient disclosure in light of the heightened
chance that model returns may give erroneous inferences about future results. Inherent
limitations of the model should be disclosed,
including the fact that model returns are created with the benefit of hindsight and may
thus not reflect material market and economic
factors. Assumptions underlying the model
must also be disclosed. Further, if the adviser’s
clients had actual performance results that
were materially different from those portrayed
in the model, this fact must be disclosed.10
Hypothetical Back-Tested Performance – The
SEC is highly suspicious of the use of hypothetical back-tested performance. It should
only be included in presentations to highly
sophisticated (non-retail) clients, and only with
clear and comprehensive disclosure regarding
the limitations of back-tested performance.11
FINRA strictly prohibits the presentation
of model or hypothetical back-tested performance.12 However, FINRA does permit the use
of hypothetical backtested index performance.
FINRA recently took enforcement action
against a firm for presenting index/benchmark
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Master-Feeder Structures – Composite Construction
The Guidance Statement recognizes that
firms managing master-feeder structures may
have difficulty determining which level of the
fund structure is relevant for composite inclusion. For traditional asset classes, a composite should include the fund in which a prospective client may actually invest. However,
the Guidance Statement recognizes that in
master-feeder structures, it may be more
appropriate in some instances to instead
include the master fund in the composite.
In determining what level of the structure
to include in the composite, the Guidance
Statement advises firms to consider:
1. The level of the investment structure
that is effectively subject to investment
management decisions; and
2. The level of investment structure in
which prospective clients can effectively
invest.
Most importantly, the Guidance Statement
gives firms latitude to determine the appropriate investment level to include in the
composite (provided that assets are not
double-counted). The firm must document
its policies and procedures for determining the appropriate level of the structure to
include in the composite, and must apply
such procedures consistently.
4
Methodology and Frequency
for Valuation of Illiquid
Investments
Practice Note on Composite Construction
for Master-Feeder Structures – Neither the
SEC nor FINRA has adopted clear guidance on including master-feeder fund performance information in advertising materials.
The SEC proposed, but did not adopt, a
rule that would have required master-feeder
mutual fund advertisements that contained
performance figures to include, with equal
prominence, the performance of all feeder
funds that invest in the same master fund.14
The SEC does, however, require that the fee
table included in a master-feeder registered
fund prospectus aggregate the feeder fund’s
pro rata master fund expenses and direct
expenses of the feeder fund.15 FINRA’s prohibition on presenting related performance
information does not prohibit the presentation of a master fund’s performance in feeder
fund marketing materials to the extent that
it reflects the performance of the same portfolio of securities in which the feeder fund’s
assets are invested.16
For periods beginning on or after January 1,
2011, portfolio valuation must comply with
the definition of fair value included in the
GIPS Valuation Principles and valuation hierarchy, and firms must disclose if a composite’s
valuation hierarchy materially differs from the
GIPS valuation hierarchy.19 The Guidance
Statement makes it clear that this requirement
is equally applicable to alternative investment
valuation.
Notably, however, the Guidance Statement
recognizes that for some alternative investments, market prices may not be readily available on a monthly basis and/or at the time
of large cash flows due to an investment’s
illiquidity, lack of transparency in underlying
funds or because the pricing source provides
valuations on a less frequent basis. In such
cases, the Guidance Statement permits firms
to value portfolios on a less frequent than
monthly basis (but no less frequent than
annually).
The Guidance Statement contains specific
guidance in a fund of funds context, noting
that the subscription and redemption cycles
of the underlying fund (that is, when such
funds must necessarily determine value) may
determine the frequency of the firm’s valuations for a fund of funds. Firms must disclose
if they valued portfolios less frequently than
monthly. The GIPS Standards provide similar
flexibility with respect to valuation frequency
for other types of illiquid investments. For
example, the GIPS Standards require that real
estate investments be valued at least quarterly,
and require that private equity investments
be valued at least annually.20 The firm must
adopt appropriate valuation procedures for
determining fair value on a less frequent basis
than monthly, and must apply such procedures consistently.
Practice Note on Valuation Frequency –
All registered advisers should have established valuation procedures pursuant to Rule
206(4)-7 under the Advisers Act that address
the methodology and frequency of alternative investment valuations.21 For many registered advisers, these procedures may simply
Input Data
The current GIPS Standards require that
when accounting for investment transactions,
assets/liabilities must be recognized on a trade
date basis (T+3 is sufficient) and not on a settlement date basis.17 The Guidance Statement
acknowledges that hedge fund subscriptions
and/or redemptions often cannot be recognized within three days of the transaction
because the fund administrator’s confirmation
may be provided only several days or even
weeks after the subscription/redemption trading order has been submitted, and the final
quantity and settlement price is not known
until the administrator’s confirmation has
been received.
For alternative investments, firms may need
to differentiate between the date of placing a
subscription/redemption order and the date
of the effective asset ownership transfer. The
Guidance Statement states that the date of
the execution or transfer of ownership will
be considered the “trade date” for GIPS purposes, notwithstanding that such date may be,
and often is, more than three days following
the submission of a subscription for such
investment.18
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Vol. 19, No. 11 • November 2012
Practice Note: From an administrative perspective, this is likely the most efficient option
(it does not present error correction concerns), but this approach may have limitations
from a marketing perspective to the extent
prospective investors wish to see more updated
performance information.
be incorporated into a firm’s GIPS policies
and procedures consistent with the Guidance
Statement.
Similarly, the Guidance Statement permits
the use of estimated values for alternative
investments where final valuations may not be
available provided that the firm has adopted
composite-specific valuation policies and
procedures for determining estimated value.
The GIPS Standards provide similar relief in
the private equity context.22 The Guidance
Statement provides three possible scenarios in
the fund of funds context for how a firm may
determine value using the estimated values of
underlying funds:23
(1) Produce a compliant presentation on
a timely basis using the estimated value to
determine fair value after making a determination that estimated value is a reliable basis
for determining fair value, based on an established and documented process for determining estimated value. Firms must disclose that
performance reflects estimated values, including the percentage of composite assets for
which estimates are used and any other information necessary or appropriate to enable
the recipient to evaluate the performance
presented.
Practice Note: Firms taking this alternative
approach must update estimated values once
final values are obtained. Any differences
between estimated and final values must be
treated as if they were errors, consistent with
a firm’s GIPS error correction procedures.
Because of the administrative burden and
requirement to republish performance in the
event of material errors, this may not be the
easiest of the three approaches.
(2) Produce a compliant presentation on a
timely basis using last available historical final
values to determine fair value.
Practice Note: As described above, registered advisers may be able to rely on their
established valuation procedures in taking this
approach. However, the potential administrative burdens related to error correction are
still present with this option to the extent that
the fair value presented is later shown to have
been materially different from the final values.
(3) Produce compliant presentations with a
time lag only after final valuations have been
received.
THE INVESTMENT LAWYER
Performance Calculation –
Fees and Expenses
The Guidance Statement reaffirms that the
GIPS Standards permit composite returns
to be presented on either a gross-of-fees or
net-of-fees basis, so long as the returns are
clearly identified as such. For a fund of funds,
net composite returns must reflect the deduction of the fund of funds’ fees and expenses
in addition to any fees and expenses charged
at the underlying fund level that are passed
through to the investor. Similarly, net-offees returns for master-feeder funds must
reflect any fees and expenses charged at the
feeder-fund level.
Firms may present performance gross or
net of fees.24 When presenting returns for a
fund with multiple classes of shares or a composite strategy with multiple portfolios, netof-fee returns must generally either: (1) reflect
all actual fees from all share classes, series
and portfolios; or (2) deduct a model fee that
reflects the highest investment management
fee incurred among all share classes, series and
portfolios in a composite.25
However, the Guidance Statement
acknowledges that where portfolios in a
composite are subject to both asset-based
and performance fees, it may be impossible
to determine which investment management
fee is the highest among all portfolios in a
composite. In such cases, net-of-fee returns
may reflect deduction of the highest model
fee applicable to the specific prospective client or intended recipient of the compliant
presentation so long as the net-of-fee returns
presented are no higher than the returns
that would have been presented had actual
fees been used. The Guidance Statement
acknowledges that the highest model fee
for prospective clients may differ, resulting
in the creation of multiple GIPS-compliant
presentations for the same composite.26
6
For single-fund composites that include discretionary side-pockets – that is, side-pockets
created for investment purposes at the discretion of the adviser – composite performance
must be presented both including and excluding
the side-pocket, despite the fact that a potential
investor may not participate in the side-pocket.
This reflects that: (1) the prospective client has
an interest in performance excluding the sidepocket because the investor will not participate
in the side-pocket’s performance; and (2) the
potential client still has an interest in the composite’s overall performance history. Where the
composite includes more than one account,
discretionary side-pocket performance must
be included, but performance excluding such
performance is not required.29
Where a side-pocket (or particular
assets included in the side-pocket) is nondiscretionary—that is, the adviser no longer
has investment discretion over the side-pocket
or particular assets in the side-pocket—the
side-pocket must be excluded from the composite. Noting that illiquidity alone is not a sufficient basis for determining that a side-pocket is
non-discretionary, the Guidance Statement
contains specific guidance for determining when a side-pocket is non-discretionary.
Specifically, a side-pocket may only be classified as non-discretionary where all of following criteria are met: (1) it is segregated into
a separate sub-portfolio; (2) its assets are no
longer considered in the fund asset allocation
and investment process; (3) there are no investment decisions for the side-pocket assets (other
than monitoring and liquidating); and (4) sidepocket assets are subject to no (or reduced)
investment management fees.
Practice Note on Side-Pockets: In a departure from the long-standing approach to allow
firms to independently define and apply their
own definition of “discretion,” the Guidance
Statement instead provides a standardized
definition to be used by all compliant firms
for side-pocket discretion determinations. The
standardized definition is likely aimed at preventing firms from creating side-pockets for
the purpose of removing poor performing
assets from a portfolio and composite. While
the SEC has not endorsed GIPS’ specific
guidelines for determining whether a sidepocket is discretionary, the SEC shares the
Practice Note on the Presentation of Grossof-Fee Returns: Compliance with the GIPS
Standards is subject to all applicable SEC and
FINRA rules. While the GIPS Standards permit the presentation of gross-of-fee returns,
both the SEC and FINRA generally require
that net-of-fee returns be presented side-byside and with equal prominence as gross-of-fee
performance. By way of an exception, the SEC
permits stand-alone gross-of-fees returns with
appropriate disclosures in one-on-one presentations and presentations to consultants.27
FINRA requires returns to be presented only
net-of-fees or both net-of and gross-of-fees.
Practice Note on the Presentation of Model
Fees: The Guidance Statement is generally
consistent with applicable SEC requirements.
The SEC generally requires that actual fees
be used by an adviser when presenting net-offee performance; however, the SEC permits
advisers to use a model fee (with sufficient
disclosure) if the model fee is equal to the
highest fee charged to any account managed
in the same investment strategy included in
the performance presented for the applicable
period.28
Side-Pockets and Illiquid
Investments
Many alternative investment strategies
utilize “side-pockets” to segregate illiquid
investments or assets held for a special purpose from other investments. The existence of
side-pockets can create difficulties in composite construction and performance calculation.
Typically, only investors in a pooled fund at
the time the side-pocket is created are entitled
to the side-pocket’s returns. Further, investors may not be able to redeem assets held
in a side-pocket until after the side-pocket
is liquidated. The Guidance Statement clarifies that the treatment of side-pockets differs
depending on whether the side-pocket is
discretionary or non-discretionary; however,
whether discretionary or non-discretionary,
a GIPS-compliant presentation must disclose
the existence of side-pockets. For composite strategies that intend to invest in illiquid assets, the Guidance Statement adds
a requirement to specifically disclose such
intent.
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Vol. 19, No. 11 • November 2012
make use of formal legal structures to avoid
inclusion of certain portfolios or assets in the
definition of the firm.
0.A._ Where a portfolio is subject to
oversight by a third party who is theoretically free to follow the firm’s advice or not,
firms must include the portfolio in the firm
definition if the firm can demonstrate that it
effectively exercises discretionary investment
management and can provide documented
evidence that all investment advice has been
implemented accordingly.
1. Input Data
Input Data – Requirements
1.A._ If the pricing source does not provide monthly or more frequent valuations or
underlying investments do not lend themselves
to monthly valuations, firms must create a
valuation policy that addresses how to determine fair values less frequently than monthly
(for example, on subscription or redemption
dates for underlying funds).
1.A._ In all cases, valuations must be conducted at least on an annual basis.
1.A._ If a firm uses estimated values, the
firm must assess to what extent the estimated
values represent the current fair value and can
be used for GIPS compliance purposes and
how they will fit within the composite-specific
valuation policies and procedures.
a.
If using estimated values, the firm
must consider them to be the best approximation of the current fair value and this must be
defined in the firm’s fair valuation policy.
b.
If using the last available historical
final values, the firm must consider them to
be the best approximation of the current fair
value and this must be defined in the firm’s
fair valuation policy.
1.A._ Firms must establish the use, if
any, of estimated values, last available historical values and the treatment of subsequent final values in their composite-specific
fair valuation policy, which must be followed
consistently and made available upon request.
1.A._ If the firm uses estimated values
or the last available historical values, when
final values are received the firm must assess
the differences in values and the impact on
composite assets, total firm assets, and performance. Firms must consider such differences
in light of the Guidance Statement on Error
GIPS view that side-pockets should not be
used to hide the performance of poorly performing assets.30 In addition, the SEC requires
disclosure regarding any material factors that
affect performance.31
Conclusion
The Guidance Statement provides valuable
insight and guidance into how firms claiming
compliance with the GIPS Standards should
apply the standards to alternative investments and non-traditional investment structures. However, the guidance should not be
viewed in a vacuum. Firms managing traditional asset classes also need to reconsider
certain aspects of performance presentation and reporting in light of the Guidance
Statement. In addition, firms must be mindful that where the GIPS Standards conflict
with applicable SEC and/or FINRA rules and
guidance, the firm must comply with the rules
of the regulatory authorities to the extent
they impose stricter requirements than those
imposed by GIPS.
For a summary of the recommendations
and requirements contained in the Guidance
Statement that add to or deviate from the current GIPS Standards, please refer to the following Summary of Deviations from and Additions to
GIPS Standards outline:
Summary of Deviations From and
Additions to GIPS Standards:
Requirements and Recommendations
Based on the Guidance Statement on
Alternative Strategies and Structures
The following summarizes how the guidance contained in the Guidance Statement
might look if codified as GIPS requirements
and recommendations (to the extent that
those recommendations or requirements add
to or deviate from the current GIPS 2010
Standards).
0. Fundamentals of Compliance –
Requirements
0.A._ In situations where it may be difficult to assess whether a particular portfolio
should be included in the definition of the
firm, firms must bear in mind that a “substance over form” principle should always be
applied. It would be inappropriate and against
the ethical spirit of the GIPS Standards to
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8
Correction and the firm’s error correction
policies.
Input Data – Recommendations
1.B._ Firms should establish a proper
internal segregation of duties with respect to
valuations to ensure that the valuation is carried out by a unit functionally separate from
the portfolio management division or chain of
command/reporting structure.
1.B._ If differences between the estimated
and final values are consistently material, the
firm should reassess whether it is proper to use
estimates as the fair value.
2. Calculation Methodology – Requirements
2.A._ If presenting gross-of-fees returns
for a fund of funds composite strategy, firms
must present the gross-of-fees returns net of
all of the underlying funds’ fees and expenses.
2.A._ If presenting net-of-fees returns for
a fund of funds composite strategy, firms
must present the composite net of both the
overall fund of funds investment management
fee and all of the underlying funds’ fees and
expenses.
2.A._ Net-of-fees returns for masterfeeder funds must reflect any fees charged at
the feeder fund level.
2.A._ When presenting returns for a fund
with multiple classes of shares or a composite
strategy with multiple portfolios, net-of-fee
returns must generally either (1) reflect all
actual fees applicable to all share classes
and series; or (2) deduct a model fee that
reflects the highest investment management
fee incurred by all portfolios in a composite.
2.A._ Where it is impossible to determine
which investment management fee is the highest among portfolios in a composite, such as
where portfolios in a composite are subject to
both asset-based and performance fees, netof-fee returns may reflect deduction of the
highest model fee applicable to the specific
prospective client or intended recipient of the
compliant presentation so long as the net-offee returns presented are no higher than the
returns that would have been presented had
actual fees been used.
2.A._ Any client-directed external cash
flow between a master fund and a feeder fund
must be properly accounted for in calculating
gross-of-fees and net-of-fees returns, subject
to the firm’s Significant Cash Flow policy.
3. Composite Construction – Requirements
3.A. If a firm manages a multi-level masterfeeder structure where funds may be invested in
each other, the firm must determine which level
of the master-feeder structure is relevant for
composite inclusion. Firms must document
their policies and procedures, and apply them
consistently on a composite-specific basis.
3.A. Firms must not double-count assets
when determining Total Firm Assets.
4. Disclosure
Disclosure – Requirements
4.A._ Firms must disclose if any portfolios in a composite are valued less frequently
than monthly and/or are unable to be valued
on the date of large cash flows, and must disclose why such valuations are not possible.
4.A._ Firms must disclose whether estimated values are used for the composite
and any additional information necessary or
appropriate in connection with the use of estimated values.
4.A._ Firms must disclose if any portfolio
in the composite contains side-pockets.
4.A._ If a firm employs complex investment strategies, the composite description
should be more detailed to enable investors to
understand the strategy.
4.A._ Firms must disclose in the composite description whether illiquid securities are a
significant part of the composite strategy or
if there is a strategic intent to invest in illiquid
investments.
4.A._ Firms must disclose if a composite
contains investments that become illiquid or
if an illiquid investment ceases to be managed in a discretionary manner, to the extent
that the firm determines that the situation
rises to the level of a significant event.
Disclosure – Recommendations
4.B._ Many alternative investment
strategies are complex and may need more
explanation than traditional asset classes.
Firms should evaluate the potential need for
increased disclosure in such situations where
clarity is needed.
4.B._ Firms should disclose if pricing
has been performed internally and not by an
external third party.
5. Presentation and Reporting
Presentation and Reporting – Requirements
5.A._ Firms must disclose the percentage
9
Vol. 19, No. 11 • November 2012
composite performance (i.e., related performance) in
connection with the sale of a private fund that relies on
Section 36(c)(7) from registration under the investment
Company Act of 1940. In addition, the authors believe
a comparison of the GIPS Standards with the positions
taken by FINRA is instructive as a comparasion of different advertising regimes.
of assets in the composite for which estimated
values are used.
5.A._ If a firm manages a single-fund
composite that includes discretionary sidepockets, performance must be presented both
including and excluding the side-pocket.
5.A._ If a firm manages a multi-portfolio
composite that includes one or more portfolios
with discretionary side-pockets, performance
must include performance of the discretionary side-pocket (performance excluding such
side-pocket performance is not required).
5.A._ Firms must not classify side-pocket
performance as non-discretionary unless all of
the following criteria are met:
(1) It is segregated into a separate subportfolio;
(2) Its assets are no longer considered
in the fund asset allocation and investment
process;
(3) There are no investment decisions for
the side-pocket assets (other than monitoring
and liquidating); and
(4) Side-pocket assets are subject to no (or
reduced) investment management fees.
5.A._ Where a side-pocket (or particular assets included in the side-pocket) is
non-discretionary (the adviser no longer has
investment discretion over the side-pocket or
particular assets in the side-pocket), the performance of side-pocket (or particular assets) must
be excluded from the composite performance.
5.A._ Firms must not claim that illiquid
securities are non-discretionary just because
of their illiquidity in order to exclude the
performance of the illiquid securities from
the portfolio or the composite.
Presentation
and
Reporting
–
Recommendations
5.B._ If a firm believes that the presentation of additional risk measures would help a
prospective client understand the compliant
presentation, the firm should add those risk
measures to the compliant presentation.
2. The SEC regulates investment adviser performance presentation and advertising under Section
206(4) of the Investment Advisers Act of 1940 (the
Advisers Act), Rule 206(4)-1 thereunder, and numerous no-action letters, enforcement actions and other
public statements. Similarly, FINRA regulates performance presentation and advertising in its Conduct
Rule (NASD Rule 2210), Notices to Members and
enforcement actions.
3. See Guidance Statement, Question & Answer 4.1.2.
4. GIPS Handbook, Second Edition, 2006, Explanation
of the Provisions of the GIPS Standards and Verification,
Fundamentals of Compliance – Definition of the Firm
Requirements, 0.A.3, Application 1; GIPS Guidance
Statement on Wrap Fee/Separately Managed Account
(SMA) Portfolios, Effective January 1, 2011.
5. See Guidance Statement, Question & Answer 4.4.4.
6. See GIPS 2010, introductory text to Standard 8;
GIPS Guidance Statement on Wrap Fee/Separately
Managed Account (SMA) Portfolios (effective Jan. 1,
2011).
7. See Clover Capital Management, Inc., SEC No-Action
Letter (Pub. Avail. Oct. 28, 1986) (Clover Capital).
8. See NASD Interpretive Letter to Collins/Bay Island
Securities (Sept. 14, 2004); NASD Interpretive Letter
to Davis Polk & Wardwell (Dec. 30, 2003); NASD
Interpretive Letter to Securities Industry Association
(Oct. 2, 2003) at fn.1.
9. See Guidance Statement, Question & Answer 4.3.1.
10. See Clover Capital, supra n.7.
11. For more information and additional required disclosures, see, e.g., In re Market Timing Systems, Inc. et al.,
SEC Release No. IA-2047 (Aug. 28, 2002); In re Schield
Management Company et al., SEC Release No. IA-1872
(May 31, 2000); In re Leeb Investment Advisers et al.,
SEC Release No. IA-1545 (Jan. 16, 1996); In re Patricia
Owen-Michel, SEC Release No. IA-1584 (Sept. 27, 1996).
12. See NASD News Release, “NASD Fines Citigroup
Global Markets, Inc. $250,000 in Largest Hedge
Fund Sales Sanction to Date,” Oct. 25, 2004; NASD
Interpretive Letter to Securities Industry Assn., Oct.
2, 2003; Bear Stearns & Co., Inc., n/k/a J.P. Morgan
Securities Inc. Letter of Acceptance, Waiver and Consent
No. 2007011145701, Aug. 2009.
Notes
1. The authors understand that marketing material for
the sale of a security under the jurisdiction of FINRA
would not generally involve the GIPS Standards, which
apply to the sale of an adviser’s strategy. Arguably, however, the GIPS Standards may be implicated in connection with the presentation of a GIPS-compliant firm’s
THE INVESTMENT LAWYER
13. See SEI Investments Distribution Co. Letter of
Acceptance, Waiver and Consent No. 2009018186201
(Feb. 14, 2012).
14. See SEC Release No. 33-7143 (Feb. 23, 1995).
10
15. See Item 3 of Form N-1A, Instruction 1(d)(i).
16. See NASD Interpretive Letter to Securities Industry
Association (Oct. 2, 2003) at fn.1.
17. See GIPS 2010, Standard 1.A.5; Glossary (Definition
of Trade Date Accounting).
18. See Guidance Statement, Question & Answer 4.2.1.
19. See GIPS
Requirement 8.
2010,
Standard
1.A.2.;
Valuation
apply to illiquid investments generally. Private equity and
real estate assets are also subject to the GIPS guidance
statements specific to such asset classes.
24. See GIPS 2010, Standard 5.A.1.b.
25. See Guidance Statement, Section 2.3.1; Question &
Answer 4.4.1.
26. See id.
27. See Investment Company Institute, SEC No-Action
Letter (Pub. Avail. Sept. 23, 1988).
20. See GIPS 2010, Standard 6.A.2 and 7.A.2.
28. See J. P. Morgan Investment, Inc. (May 7, 1996).
21. See Compliance Programs of Investment Companies and
Investment Advisers, SEC Release IA-2204 (Dec. 17, 2003):
“We expect that an adviser’s policies and procedures, at a
minimum, should address the following issues to the extent
they are relevant to that adviser:…processes to value client
holdings and assess fees based on those valuations.”
29. See Guidance Statement, Section 2.4.3.
22. See GIPS Guidance Statement of Private Equity
(effective Jan. 1, 2011), discussion regarding GIPS
Standard 7.A.1.
23. Although the Guidance Statement provides specific
examples with reference to funds of funds, we believe
the same principles regarding the use of estimated values
30. See SEC Charges Georgia-Based Hedge Fund
Managers With Fraud in Valuing a “Side Pocket” and
Theft of Investor Assets, Statement of Robert B. Kaplan,
Former Co-Chief of the SEC’s Asset Management Unit,
SEC News Digest (Oct. 19 2010) (“Side pockets are not
supposed to be a dumping ground for hedge fund managers to conceal overvalued assets…deceive[d] investors
about the fund’s performance and extract[ed] excessive
management fees based on the inflated asset values in a side
pocket.”).
31. See Clover Capital supra n.7.
Copyright © 2012 CCH Incorporated. All Rights Reserved
Reprinted from The Investment Lawyer November 2012, Volume 19, Number 11, pages 17–27,
with permission from Aspen Publishers, Wolters Kluwer Law & Business, New York, NY,
1-800-638-8437, www.aspenpublishers.com