Background
The treatment of carveouts within the GIPS standards (formerly, the AIMR Performance Standards) has been a long and winding road since the inception of the standards back in the early 1990s. Initially, the standards permitted the carving out of a portion of portfolio assets into individual segments for the creation of separate and distinct strategies so long as there was an allocation of cash to the strategy. However, in 2010, the GIPS Executive Committee determined that allocating cash to carveouts could potentially be misleading since it did not portray a fair representation of the performance that would have been achieved with a stand-alone portfolio dedicated to that strategy. This led to carveouts with allocated cash being disallowed under the standards.
It was not until the release of the 2020 edition of the GIPS standards that firms would be permitted to once again allocate cash to carveouts for inclusion within GIPS Composite Reports. The most recent change, which came with a set of new requirements, was made primarily to encourage more firms to comply with the standards that would otherwise struggle with compositing accounts. In particular, the change was made to appeal to certain advisors, such as private wealth managers, whose investors generally are comprised of highly customized retail accounts that use a blend of the firm’s building block investment strategies.
Just when we thought that carveouts were back, the Securities and Exchange Commission (SEC) released the Marketing Rule, which replaces the current advertising rule that was created to protect investors from potentially misleading advertisements. The new Marketing Rule, and the related Adopting Release, were issued in December 2020 with an effective date of May 4, 2021. Investment advisors were given an 18-month window, ending in November 2022, to bring their firm into compliance with the new rule. The rule itself is comprehensive and includes provisions on testimonials and endorsements, including solicitations, third-party ratings, and performance advertising. Under the new rule, GIPS Reports are considered advertisements. While most of the provisions regarding performance advertising are consistent with the GIPS standards, there are areas which could be described as conflicting. One of these areas in particular may compel advisors to revisit their decision on including carveouts with allocated cash within their composites.
Carveouts vs. Extracted Performance
In an effort to understand the differences between the GIPS standards and the marketing rule, it might be helpful to revisit the definition of a carveout. The GIPS standards define a carveout as, “a portion of a portfolio that is by itself representative of a distinct investment strategy.” GIPS requires that carveouts are representative of a standalone portfolio and that cash is allocated on a consistent and timely basis in instances where no separate cash account is maintained. Furthermore, firms are required to create carveouts with allocated cash from all portfolios and portfolio segments within the firm that are managed to that strategy for inclusion within a composite.
Within the SEC’s Marketing Rule, carveouts are addressed as part of the performance advertising section on extracted performance. The marketing rule defines extracted performance as the performance results of a subset of investments that has been extracted from a portfolio (final rule 206(4)-1(e)(6)). Unlike the GIPS standards, there is no requirement under the final rule to include an allocation of cash with extracted performance. Instead, the rule is flexible and requires that advisors determine whether an allocation of cash is warranted based on the facts and circumstances of the situation. Furthermore, the Marketing Rule requires that advisors presenting extracted performance in an advertisement provide, or offers to provide promptly, the performance results of the total portfolio from which the performance was extracted (final rule 206(4)-1(d)(5)). This requirement mitigates the risk of advisors potentially cherry-picking the best performing securities and allows investors to analyze the extracted performance as well as the overall portfolio from which it was generated.
Carveouts within the GIPS standards and extracted performance within the SEC Marketing Rule are not an apples-to-apples comparison. While both carveouts and extracted performance relate to a portion or subset of a portfolio, the way in which they are advertised or presented is different. As explained earlier, GIPS requires that firms create carveouts for each portfolio and portfolio segment at the firm managed to the same strategy, and group them into a composite for performance reporting purposes. Under the Marketing Rule, extracted performance explicitly pertains to a single portfolio from which performance is extracted and advertised. When extracted performance from multiple portfolios is grouped together, effectively creating a composite of extracts, the Marketing Rule considers this performance to be hypothetical since the performance itself was not actually achieved by a portfolio of the investment advisor. The SEC believes that this performance carries a greater risk of being misleading and therefore requires that it be subjected to additional protections when being advertised.
Hypothetical Performance
The Marketing Rule defines hypothetical performance as performance results that were not actually achieved by any portfolio of the investment advisor (final rule 206(4)-1(e)(8)). Examples of hypothetical performance provided within the rule include, but are not limited to, performance derived from model portfolios, back-tested performance, and targeted or projected performance. Based solely on the definition, most instances of carveout performance presented in accordance with the GIPS standards would be considered hypothetical since the performance is not derived from an actual portfolio of the advisor. Instead, the performance is typically aggregated from all the advisor’s portfolios that are managed to the same strategy. Given that the performance is derived from an aggregation of multiple portfolios, the SEC believes there is a risk that advisors can cherry-pick investments across multiple portfolios and call it a strategy.
The Marketing Rule prohibits advertisements from including hypothetical performance unless additional steps are taken to protect investors and mitigate the risk of the advertisement from being potentially misleading. The requirements were put in place to make sure investors receiving hypothetical performance are of the appropriate level of sophistication and are provided with the resources needed to independently analyze the information. The rule includes three broad requirements that must be met when presenting any kind of hypothetical performance.
Policies and Procedures
First, advisors must establish and adopt policies and procedures to ensure that the hypothetical performance is relevant to both the financial situation and investment objectives of the investor to which it is being provided. It is important to note that this does not need to be assessed at the individual investor level, but rather based on the intended audience of the performance. Advisor policies and procedures should also address how the distribution of the performance would be limited to only those investors that the advisor has deemed to have the resources and financial expertise.
Currently, under the GIPS standards, firms must establish policies and procedures for identifying prospective clients, which includes determining if, and when, an interested party qualifies to invest in a strategy. However, these policies and procedures generally would not be adequate in determining the financial situation and investment objective of prospects. Furthermore, while the GIPS standards require policies and procedures surrounding the distribution of GIPS reports, it is unlikely that these policies and procedures cover the limitation of such distribution.
Criteria and Assumptions
Advisors are also required to provide sufficient information for the intended audience receiving the performance to analyze the criteria and assumptions that went into deriving the hypothetical performance. Among other things, this generally will include a detailed description of the calculation methodology as well as any assumptions that went into deriving the performance. Where applicable, firms are also required to include the probability associated with any outcome that was assumed in calculating the hypothetical performance.
Again, it would appear as though the presentation and disclosure requirements of the GIPS standards would fall short of meeting the requirements for hypothetical performance under the Marketing Rule. For starters, the GIPS standards do not require the disclosure of calculation methodologies, but rather indicate that these policies are available upon request. Included within these calculation methodologies for carveouts would be the synthetic allocation of cash, which would be instrumental to understanding how the performance was calculated. Additionally, the GIPS standards do not require firms to disclose the criteria that went into the construction of carveout composites. This would likely be required for a user of the advertisement to understand how the performance was calculated.
Risks and Limitations
Lastly, advisors are required to provide sufficient information so that the intended audience can understand the risks and limitations associated with the hypothetical performance. This information will typically need to include the inherent risks associated with hypothetical performance in general as well as any risks associated with the specific performance being provided.
Under the GIPS standards, information pertaining to risks and limitations specific to a composite strategy are normally included as part of the composite definition, which is required to be disclosed within the GIPS Report. Currently, the standards require the inclusion of material risks that could have had a significant influence on the historical returns or that are useful in understanding the strategy and its future expected returns. It is possible that these disclosures will need to be expanded to include more general information pertaining to the inherent risks of hypothetical performance in order to comply with the Marketing Rule. Additionally, it will be important to include any known reason why the performance of the carveout composites might differ from the performance of an actual portfolio, such as the impact of allocating cash synthetically.
Takeaways
As you might imagine, many industry professionals recognized the potential difference in treatment as it relates to carveouts and brought it to the attention of the SEC during the comment period. Despite the pushback, the SEC made it clear in the Adopting Release that, “…the final rule does not prohibit an advisor from presenting a composite of extracts in an advertisement, including composite performance that complies with the GIPS standards, but this performance information is subject to the additional protections that apply to advertisements containing hypothetical performance…”
There is no question that these additional requirements surrounding carveouts and hypothetical performance will be burdensome for advisors to comply with. It will be difficult for advisors to distribute GIPS Reports containing carveouts to mass audiences, such as providing on a firm website, since advisors will first be required to understand the financial situation and objectives of the recipients of these reports. Advisors utilizing carveouts will need to assess the impact that these new requirements will have on their current policies and procedures and make the necessary adjustments before the fast approaching November 2022 adoption deadline.
For more guidance about the SEC Marketing Rule and its impact on GIPS-compliant firms, please contact us to schedule a conversation.
We would be pleased to provide further information related to this subject matter. For more information, contact Joshua E. Kramer, Manager, Investment Industry Group at jkramer@kmco.com.
