GIPS Composite Construction
Introduction
GIPS Composite Construction can sometimes be the hardest part of GIPS compliance for the firm to create. Your firm may already have composites in existence or you may be creating composites for the first time. Regardless of the situation, a GIPS compliant firm must utilize all of rules associated with the GIPS guidelines in order to adequately address the GIPS requirements around the actual creation of the GIPS Composite Description, along with the GIPS Construction policies.
What Are Investment Composites?
An investment composite is an aggregation of one or more portfolios managed according to a similar investment mandate, objective, or strategy and is the primary vehicle for presenting performance to prospective clients.
Example: Your firm is managing 100 accounts and one of the strategies is to invest in Small Cap Value stocks. Your firm has 70 accounts invested in this mandate. These 70 accounts will be grouped form a composite.
GIPS Composite Requirements
The firm must establish reasonable criteria that support the fundamental principle of fair representation. A variety of criteria must be analyzed to identify whether portfolios are similar and should be grouped together into a composite for comparison purposes. The firm should also consider the definition and construction of similar products found within the competitive universe.
If a firm presents its record for a particular equity classification, all portfolios meeting pre-established criteria for that class must be represented. A firm cannot include some and exclude others at will.
GIPS Requirement 3.a.2 - GIPS Fee Paying Portfolios
All fee paying, discretionary portfolios are to be included in at least one composite that are defined by investment mandate, objective or strategy.
GIPS Non-discretionary portfolios must not be included in a firm’s composites. A discretionary portfolio is one in which buy and sell decisions are made by a portfolio manager. On the other hand, the manager of a non-discretionary portfolio does not have full discretion over how the money is invested.
GIPS Composite Benefits
Composites should enable clients to compare the performance of one firm to another. Using GIPS® Standards to Compare Portfolio Managers means the composites must be representative of the firm's products and be consistent with the firm's marketing strategy. Creating GIPS composites allows for:
Transparency: GIPS include making a composite presentation of an investment firm, including performance numbers derived using a standard methodology. This provides data transparency, making it easier for potential/existing investors to understand and analyze a firm.
Accuracy: Accuracy of performance data instills confidence in investors.
Consistency: Consistency of the methodology used and the data input to calculate performance is vital for a fair presentation, making the investment decision-making process easier.
Comparison: GIPS enable investors to compare the track record of one portfolio with another, as the same methodology and parameters are used.
Global acceptance: GIPS, therefore, are a set of standards that benefit both investment managers and investors.
GIPS Composite Construction Rules
Once you've defined the GIPS Firm definition, and compiled a master list of all portfolios, the Composite Description/Definition then must be tackled. The GIPS composite description can be as long and as short as you want it to be. Basically, include those items that you think are pertinent for someone to be able to understand what is exactly contained within the composite. The GIPS composite description must include all key features of the strategy, and assist in the GIPS Prospective Client's understanding of what they are about to invest in.
This is the first step in GIPS Composite Construction, which identifies the following:
Review the firms existing strategies, organizational structure and investment process to see if distinct strategies can be readily identified.
Review the firms existing marketing materials and discover how the firm is currently presenting its results.
Refer to the GIPS Guidance Statement on Composite Definition, and begin to develop a descriptive framework to begin to identify possible GIPS composites.
Review client agreements to test how well the actual, GIPS discretionary fee paying portfolios fit into the provisional framework. This then produces exceptions, where a portfolio has to fit into ONE composite, but doesn't really fit any of the existing ones.
Review the proposed set of composites for compliance with the GIPS Standards.
Document the GIPS composite definitions in detail, again, and review the existing composites you've created
GIPS Composite description items should include:
The type of accounts to be included (inst. Vs wrap, taxable/exempt, etc.) in the composite
If non-fee paying accounts are included
If carve-outs are included
Composite minimum account size (if any)
Product strategy
Any leverage or derivatives used, or other financial instruments
Key characteristics of the strategy: number of holdings, duration, asset allocation, etc.
Benchmark to be compared against
If illiquid securities are a significant part of the composite strategy or if there is a strategic intent to invest in illiquid investments, firms must disclose this in the composite description.
GIPS Composite Construction Best Practices
Number of Composites - In essence, build a set of composites that will accurately represent the firm's distinct investment strategies. With too few composites, the firm risks overlooking significant differences by grouping diversified portfolios together. With too many composites, the firm runs the risk of creating narrowly defined groupings that are too much alike in strategy, contain too few portfolios or assets to be useful and/or could compromise client confidentiality (someone could, based on the assets, etc derive who the clients are in the composite based on asset size, etc).
Composite Listing - The composite list & descriptions should solely reside in the policy manual, but be able to be 'pulled out' as a stand-alone document. A procedure must also be put into place whereby the composite list is reviewed, at least once a year, and any changes/updates be done at that time. In addition, the Firm should create 'sections' of the list of Composite Descriptions that can more readily identify them. For Example, create the following sections:
Marketed | Non Marketed | Terminated | Terminated Beyond 5 Years | Placeholder Composites
Broad Scope - Tunnel vision Firms often define and create composites that make sense based on what was done in the past, only to realize later that they do not fit the direction of the firm or the marketplace. Composite definitions can be changed, but redefinitions may cast doubt on the relevance of the track record, so constructing composites with an eye on the future is important.
Junk Composites - Because GIPS compliance requires all discretionary, fee-paying segregated accounts to be in composites, firms may try to group together all accounts that don’t fit neatly in any other composite. Firms may also try to create a single firm-wide composite in addition to a couple of strategy-specific composites. Most firm-wide groups are not meaningful strategies, however, and should not be referred to as composites. “Junk” composites are explicitly disallowed by the GIPS standards. If an account is unique because of client-imposed limitations such as special liquidity needs, legacy holdings, social responsibility, or other restrictions, it can be deemed non-discretionary for GIPS purposes even if it has a legal discretionary contract.
Too Many Composite Rules - There are a number of inclusion and exclusion rules that could be applied to any given composite. For example, will portfolios be removed from a composite if they drop below a certain asset value? Unless effective implementation of the strategy warrants such rules, they pose a risk to a firm’s internal control processes and also increase operational burdens. Every rule necessitates additional ongoing control protocols, and when compiling an initial track record the firm may unintentionally overlook such policies.
*Information is created from a variety/multiple sources of CFA Institute materials.
