There has been much talk in recent times about the need for the financial sector to get back to basics. Several causes may have combined to trigger the 2008 crisis, but the bewildering complexity of many products and services is widely agreed to have helped foster what was essentially a dysfunctional marketplace.
With glimmers of recovery apparent, and a broad determination to avoid any repeat of past mistakes, there is a growing appetite among institutional investors for greater transparency, clarity, and ethical certainty.
They are keen to participate in a market whose structure and guiding principles will allow them to make reasoned judgments about the relative merits of the institutions to whom they might entrust their portfolios.
This is where Global Investment Performance Standards (GIPS®) come to the fore. These voluntary ethical standards, which when adhered to by investment houses, allow potential investors to compare investment performance on a like-to-like basis.
In effect, they create a level playing-field for performance data and prevent selective or mischievous presentation of crucial information. The GIPS are not new.
These objective performance criteria were initially developed in the late 1980s (by CFA Institute with the participation of many experts and industry groups) to allow the ethical, well-intentioned investment community to put clear blue water between itself and those unscrupulous investment managers who were misrepresenting their performance to prospective clients in order to win business.
The idea was to provide those prospective clients with reliable, consistent performance metrics based on the principles of fair representation and full disclosure. It is an idea which perhaps has even greater pertinence today.
As might be expected, GIPS have grown and matured to reflect changes in the market, its products and modus operandi. What is more, interpretations continue to be developed and issued by the GIPS Executive Committee (the governing body established by CFA Institute responsible for developing and interpreting GIPS) to help firms implement and apply the standards.
After continuous refinement and appropriate extension, they now address such topics as input data, calculation methodologies, composite construction, performance presentation, and disclosures in both traditional and alternative asset classes.
The aim is to provide the potential investor with a complete analysis of how and why each firm has attained its given level of investment performance.
Needless to say, achieving and maintaining compliance with GIPS is a heavyweight undertaking for any investment institution. But the ability to indicate compliance demonstrates to potential clients that the firm has no issues with, for example, presenting returns only for best-performing portfolios, while implying that they are representative of the firm's performance as a whole.
With the GIPS standards, what you see is, in terms of historic performance, what you get (or would have got!). In addition to cherry-picking top portfolios, which is addressed in GIPS by requiring that portfolios that are managed according to the same strategy be combined into a "composite", one can think of other ways in which unscrupulous sales teams might massage their figures to lure in the unwary.
For example, the pitch to potential investors might artificially boost apparent returns by presenting a partial-period result as an annual achievement, or presenting simulated returns as an actuality.
Another practice for the unethical salesperson might be to select the most favorable measurement period for a particular portfolio, calculating returns from a low point to a high point.
GIPS are designed to forestall any such activity. They ensure that the firm's performance history is fairly represented and adequately disclosed.
Firms that claim compliance with GIPS must adhere to rules governing not only rate-of-return calculations but also the way in which returns are displayed in a performance presentation.
They are further required to make certain disclosures and encouraged to make others, assisting the user in interpreting and evaluating the reported returns.
Potential and existing clients are thus assured that the information shown in a GIPS-compliant performance presentation reasonably reflects the results of the presenting firm's past investment decisions.
They are also assured that the returns are calculated and presented on a consistent basis and that they are objectively comparable to those reported by other firms claiming compliance with GIPS.
It can readily be seen that adherence to the GIPS standards has every chance of helping restore the investment industry's battered credibility.
Investors will take a firm's compliance with the standards as an indication of its integrity and of its commitment to fairness and transparency in investment performance reporting, especially if they have been verified as compliant.
The greater the number of firms achieving compliance, the greater confidence there will be among investors. It may take some time for this to filter down from the institutional sector to the retail market, but the possibility of a benign cascade is very great.
In some markets, compliance with GIPS is the minimum that potential investors expect, and non-compliance is thus a serious competitive hindrance to a firm's winning new institutional business.
It should also be noted that GIPS are applied consistently across territories and regulatory regimes, sitting above and beyond local practices and traditions. This means that compliance effectively becomes a passport for firms looking to compete in the international arena.
In addition to securing the interest and approval of potential clients, GIPS can also help firms improve their own routines, processes and practices.
Compliance with GIPS requires discipline and strong management, both initially before compliance is achieved and continuously as it is maintained.
The organic nature of GIPS is evidenced by the fact that the latest revisions only came into effective at the beginning of 2011. They address major contemporary concerns:
Fair value
GIPS require that all assets are valued using a fair value methodology when no market value is available, and a recommended valuation hierarchy is included in the revised standards.
Fair value can be an emotive term but, as the credit crisis demonstrated, market prices are not always available and alternative methods must be used to value investments.
The move to fair value also enables investment firms to apply GIPS in areas where they previously could not, due to the lack of market prices.
Risk disclosure
Firms are now required to present the standard deviation of the monthly returns of both the composite and the benchmark.
It is understood that, while standard deviation may not be the most sophisticated measure, it is easy to calculate, is fairly well understood, and provides a baseline of comparability.
Firms are to also include qualitative disclosures of the risks specific to the investment strategy.
Compliance statement and verification status
It is clearly important for firms that they should be able to promote their compliance with GIPS to prospective clients.
It is also important for the integrity of the GIPS initiative as a whole that there should be effective challenges which mean that compliance is far from automatic, thus making it worthwhile and valuable. Accordingly, firms can only claim compliance once they have met all the requirements of GIPS.
If desired, a firm can obtain independent verification of its compliance with the composite construction requirements of GIPS along with confirmation that its policies and procedures are designed to calculate and present performance in compliance with the standards.
While verification remains optional, the revised GIPS require firms to disclose whether or not their compliance has been verified by a third party.
They also specify the terminology that must be used to describe what is and is not covered by a verification.
This change was made in response to calls from certain parts of the investment industry to require that compliant firms should be verified as such.
Ultimately, investor expectation will determine whether verification becomes a pre-requisite for those promoting their investment capability under the auspices of GIPS.
Investors should not conclude that compliance with GIPS sautomatically gives an investment house a clean bill of health. There is still a requirement to undertake thorough due diligence that considers the background of the organisation.
The logic behind GIPS is beyond question. If we didn't already have them, someone with vision and ethical orientation would invent them tomorrow.
