May 2003
The Leverage & Derivatives Subcommittee of the
Investment Performance Council (IPC) of the
Association for Investment Management and
Research (AIMR) recently issued a public comment request regarding its proposed Leverage &
Derivatives Provisions and Guidance Statement to its
Global Investment Performance Standards (GIPS) and AIMR Performance Presentation Standards
(AIMR-PPS). Under the original GIPS and AIMR-
PPS, leverage was a disclosure issue rather than a presentation issue. Rather than requiring separate performance presentations with or without leverage, the firm was required only to disclose “[t]he presence, use and extent of leverage or derivatives, including a description of the use, frequency and characteristics of the instruments sufficient to identify risks.” In contrast, the new provisions are intended to address the calculation and presentation of returns that are affected by the use of leverage and derivatives and will apply to all composite strategies that employ leverage and/or use derivative instruments. The deadline for submitting comments on the proposed provisions was April 30, 2003. The draft provisions and the guidance materials may be found on AIMR’s website at www.aimr.com.
LEVERAGING
The Guidance Statement deems a portfolio to be leveraged if certain instruments or strategies are utilized, such as financing assets through liabilities
( e.g., margin) or using futures, options, or other derivative instruments. Although the determination of whether an investment policy allows for the use of leverage varies according to the particular circumstances, investment policies should be considered as permitting the use of leverage if the policy permits variations in the exposure and if the manager has the option of implementing these exposure levels.
DERIVATIVES
Examples of instruments and strategies identified in the Guidance Statement as potentially creating leverage include: margin borrowing; short-selling securities; long or short futures, options and forwards; long/short strategies; swap agreements; and combinations of these strategies/instruments.
CURRENCY HEDGING
Whether currency hedging involves leverage such that the new Leverage & Derivatives Provisions will apply depends on the particular circumstances. The
Guidance Statement identified two scenarios where such currency management would not be considered as a form of leverage: n n the investment policy mandates that foreign currencies be hedged back into the base currency and there are no significant variations in performance from the net currency gain or loss; and the firm purchases a foreign security and hedges the currency risk.
Unlike the foregoing circumstances, active currency bets will be viewed as a form of leverage that will trigger the application of the new GIPS and AIMR-
PPS provisions.
LLP

MANDATED USE OF DERIVATIVES AND
MARGIN BORROWING
The GIPS standards require that only discretionary portfolios be included in composites. If the firm’s client mandates that the firm use derivatives and margin borrowing such that the firm does not have the discretion to implement its intended strategy, the portfolio is non-discretionary and should not be included in composites. However, where the client mandates a constant use of derivatives and margin borrowing, at least for a long period of time, and the firm is capable of implementing its strategy, the portfolio may be treated as discretionary.
Composites with less than three years of performance history are not required to disclose tracking error or volatility. The IPC recommends that firms disclose the tracking error and volatility covering the most recent five and ten years, or since inception if less than ten years. From January 1, 2006 through
December 31, 2010, firms will be required to present tracking error and volatility for the most recent five years. Commencing January 1, 2011, firms must disclose the same information covering the most recent ten years.
COMPOSITE CONSTRUCTION
Portfolios that use leverage, derivatives and/or hedging may need to be included in separate composites from portfolios that do not use such instruments or strategies, as the GIPS standards mandate that composites be constructed based on investment strategy or style.
DISCLOSURES
The following disclosures are required under the current proposal: n n n
Presence, use and extent of leverage, derivatives or hedging, including a description of the use, frequency, and characteristics of the instruments and strategy sufficient to identify risks;
For multi-asset composites, disclosure regarding which segments use leverage;
For composites with leveraged strategies, the following must be disclosed:
– the composite tracking error covering the most recent three years; 1
– the methodology (arithmetic or geometric) used to calculate tracking error;
– the methodology or system that is used to calculate the Value at Risk (VaR); and
– the volatility of the monthly composite return from 2001 forward.
2
PRESENTATION AND REPORTING
For composites with leveraged strategies, the following presentations are required: n n
Minimum, average and maximum exposure for the composite for each period presented, preferably calculated based on monthly (or daily) data points; 3
Minimum, average and maximum ratio of
VaR for the composite and for the composite benchmark for each period presented. The VaR must be based on the
95% confidence interval and one month time horizon; and n
Minimum, average and maximum percentage of composite assets that are not listed on a stock exchange or equivalent including but not limited to customized derivatives, swaps, direct real estate investments, private equity and special purpose vehicles. Such percentages must be calculated by adding the absolute value of the long and short securities, divided by the composite assets.
Firms with leveraged multi-asset strategies must present total exposure, which is calculated as the sum of the weight of each segment multiplied by its respective exposure. The segments that use leverage within the multi-asset strategy must also be identified. The Guidance Statement recommends that the exposure of each individual segment be presented as supplemental information.
2
1 The tracking error is calculated as the annualized standard deviation of the arithmetic or geometric difference between the monthly composite return and the composite benchmark return.
Volatility is calculated as the standard deviation of the monthly composite returns.
3 Exposure is defined as the expected unit move in the portfolio divided by the unit move in the market.
LLP 2

Additional mandatory reporting requirements include: n
Minimum, average and maximum percentage of composite assets held in short positions for each period presented; and n
For overlay strategies, the overlay assets for each period presented.
The IPC recommends that firms present relevant risk measures, such as beta and modified duration.
CONCLUSION
The Report of the Leverage & Derivatives
Subcommittee can be found on AIMR’s website at www.aimr.com. The Report contains several examples of various calculations and a sample presentation that is compliant with the proposed provisions. The proposed effective date of the new
Leverage & Derivatives Provisions is January 1,
2005.
MICHAEL S. CACCESE*
617.261.3133
mcaccese@kl.com
CHRISTINA H. LIM*
617.261.3243
clim@kl.com
* Michael S. Caccese is a partner in the Boston office of Kirkpatrick & Lockhart LLP. He works extensively with investment firms on compliance issues, including all of the AIMR standards. He was previously the General Counsel to
AIMR 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 mcaccese@kl.com.
Christina H. Lim is an associate with K&L in the Boston office and may be reached at 617.261.3243 and clim@kl.com.
LLP 3

Kirkpatrick & Lockhart LLP maintains one of the leading investment management practices in the United States, with over 60 lawyers devoting all or a substantial portion of their practice to this area. According to the April 2002
American Lawyer , K&L is a mutual funds “powerhouse” that represents more of the largest 25 investment company complexes and their affiliates than any other law firm.
We represent mutual funds, insurance companies, broker-dealers, investment advisers, retirement plans, banks and trust companies, hedge funds, offshore funds and other financial institutions. We also regularly represent mutual fund distributors, independent directors of investment companies, retirement plans and service providers to the investment management industry. In addition, we frequently serve as outside counsel to industry associations on a variety of projects, including legislative and policy matters.
We work with clients in connection with the full range of investment company industry products and activities, including all types of open-end and closed-end investment companies, funds of hedge funds, variable insurance products, private and offshore investment funds and unit investment trusts. Our practice involves all aspects of the investment company business: from organizing and registering open-end and closed-end funds, both as series and individual portfolios, to providing ongoing advice and representation to the funds and their advisers, directors and distributors.
We invite you to contact one of the members of our investment management practice, listed below, for additional assistance. You may also visit our website at www.kl.com for more information, or send general inquiries via email to investmentmanagement@kl.com.
BOSTON
Michael S. Caccese
Philip J. Fina
Mark P. Goshko
Thomas Hickey III
Nicholas S. Hodge
LOS ANGELES
William P. Wade
617.261.3133
617.261.3210
mcaccese@kl.com
617.261.3156
pfina@kl.com
617.261.3163
mgoshko@kl.com
617.261.3208
thickey@kl.com
nhodge@kl.com
310.552.5071
wwade@kl.com
NEW YORK
Beth R. Kramer 212.536.4024
bkramer@kl.com
Richard D. Marshall 212.536.3941
rmarshall@kl.com
Robert M. McLaughlin 212.536.3924
rmclaughlin@kl.com
Loren Schechter 212.536.4008
lschechter@kl.com
SAN FRANCISCO
Eilleen M. Clavere
Jonathan D. Joseph
David Mishel
Mark D. Perlow
Richard M. Phillips
415.249.1047
415.249.1010
eclavere@kl.com
415.249.1012
jjoseph@kl.com
415.249.1015
dmishel@kl.com
415.249.1070
mperlow@kl.com
rphillips@kl.com
WASHINGTON
Clifford J. Alexander 202.778.9068 calexander@kl.com
Diane E. Ambler 202.778.9886 dambler@kl.com
Catherine S. Bardsley 202.778.9289 cbardsley@kl.com
Arthur J. Brown
Arthur C. Delibert
202.778.9046 abrown@kl.com
202.778.9042 adelibert@kl.com
Robert C. Hacker 202.778.9016 rhacker@kl.com
Benjamin J. Haskin 202.778.9369 bhaskin@kl.com
Kathy Kresch Ingber 202.778.9015 kingber@kl.com
Rebecca H. Laird 202.778.9038 rlaird@kl.com
Thomas M. Leahey 202.778.9082 tleahey@kl.com
Cary J. Meer
R. Charles Miller
Dean E. Miller
R. Darrell Mounts
202.778.9107 cmeer@kl.com
202.778.9372 cmiller@kl.com
202.778.9371 dmiller@kl.com
202.778.9298 dmounts@kl.com
C. Dirk Peterson
Alan C. Porter
202.778.9324 dpeterson@kl.com
202.778.9186 aporter@kl.com
Theodore L. Press 202.778.9025 tpress@kl.com
Robert H. Rosenblum 202.778.9464 rrosenblum@kl.com
William A. Schmidt 202.778.9373 william.schmidt@kl.com
Lynn A. Schweinfurth 202.778.9876 lschweinfurth@kl.com
Donald W. Smith
Robert A. Wittie
Robert J. Zutz
202.778.9079 dsmith@kl.com
202.778.9066 rwittie@kl.com
202.778.9059 rzutz@kl.com
LLP
® www.kl.com
BOSTON n DALLAS n HARRISBURG n LOS ANGELES n MIAMI n NEWARK n NEW YORK n PITTSBURGH n SAN FRANCISCO n WASHINGTON
............................................................................................................................................................
This publication/newsletter is for informational 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 a lawyer.
© 2003 KIRKPATRICK & LOCKHART
LLP
. ALL RIGHTS RESERVED.
®