With the release of GIPS 2020 came another change to the standards on carve-outs, marking the second time in which the guidance has changed. So, we thought it might be worthwhile to revisit the history of carve-outs guidance within the GIPS Standards.
A Brief History
Initially, the GIPS Standards (formerly, AIMR Performance Presentation Standards) permitted the carving out of a portion of portfolio assets into individual segments for the creation of separate and distinct strategies. In understanding the importance of cash and its potential impact on performance, the standards required that cash be allocated to these carve-outs on a timely and consistent basis, if not already tracked using a separate cash account. With the release of the second edition of the GIPS Standards in 2005, firms were required to start disclosing the percentage of the composite represented by carve-outs as of each period end.
Fast forward to the release of the 2010 edition of the GIPS Standards, in which the GIPS Executive Committee determined that allocation of cash for carve-outs was no longer permitted. Advocates for this change argued that carve-out returns could potentially be misleading, as they did not portray a fair representation of the performance that would have been achieved with a portfolio dedicated to that strategy. Moreover, there existed a chance that prospective investors could be led to believe that that the firm had experience in managing portfolios dedicated to a specific strategy when that may not have been the case. As a result, carve-outs were permitted for inclusion in composites only if they had a separate cash account for the segment being carved out.
Jumping to present day, the GIPS 2020 Standards once again permit firms to allocate cash for carve-outs for inclusion within compliant GIPS composite reports. The change in heart came about primarily as an attempt to increase the number of firms claiming compliance with the GIPS Standards. The thought process was that by allowing firms to allocate cash to carve-outs, more private wealth managers and managers of private market investments, who are more accustomed to multi-asset portfolios, would be encouraged to claim compliance with the standards as they would no longer be tasked with the burden of tracking separate cash accounts.
As you might imagine, GIPS 2020 includes some additional requirements for firms electing to include carve-outs using a cash allocation. These additional requirements have been introduced in order to address the previously raised concerns.
“So we’re allowed to allocate cash, but how?”
Although GIPS 2020 is once again allowing firms to allocate cash to carve-outs, the standards do not prescribe a specific methodology for the allocation of cash. The only requirement related to the allocation of cash is that it is treated consistently and on a timely basis (3.A.15). As such, there is no single methodology required when allocating cash to carve-outs.
As noted in the adopting release for firms, the CFA Institute plans to include guidance within the GIPS 2020 Handbook regarding possible methods for allocating cash. No release date for the Handbook has been announced. Until such guidance is released, acceptable allocation methods have been provided within the previously-issued GIPS Guidance Statement on Treatment of Carve-Outs, which can be found on the GIPS website.
Two of the acceptable allocations methods included within the Guidance Statement are beginning of period allocation and strategic asset allocation. Under the beginning of period allocation method, each month cash is allocated to the carved-out segment based on the carve-out beginning market value as a percentage of the total portfolio beginning market value, excluding cash.
Under the strategic allocation method, cash is allocated to the carve-out based upon target strategic asset allocation. An example might include a manager with a 60/40 equity to fixed income portfolio. If, at the beginning of the period, the portfolio held 56 percent in equites and 38 percent in fixed income securities, then 4 percent of the cash would be allocated to the equities segment and 2 percent to the fixed income segment.
Regardless of the allocation methodology selected, GIPS 2020 requires firms to disclose the policy within the compliant GIPS composite report (4.C.28).
As was the case in 2010, skeptics of the new carve-out guidance within GIPS 2020 argued that the use of carve-outs could potentially be misleading to prospective investors as the related performance may not necessarily be representative of a standalone portfolio in a dedicated strategy. In an effort to make the inclusion of carve-outs as transparent as possible, GIPS 2020 includes additional requirements for firms including carve-outs with a cash allocation in composites.
If a firm elects to include carve-outs with allocated cash in a composite, GIPS 2020 requires that it be representative of a standalone portfolio managed or intended to be managed. While this may sound intuitive, it prevents firms from carving out segments that may be misleading to a prospective investor. For instance, a firm is not permitted to carve out the two German equities included in its global balanced composite and create a German equities composite, as this would not be representative of a standalone portfolio.
Furthermore, GIPS 2020 requires firms to create carve-outs with allocated cash from all portfolios and portfolio segments within the firm that are managed to that strategy (3.A.17). As a result, firms will be prevented from cherry-picking which portfolios of a similar strategy will be carved-out with allocated cash and included in a composite.
To further address concerns related to carve-outs with allocated cash not being representative of a standalone portfolio, GIPS 2020 requires that once a firm has – or obtains – a standalone portfolio managed in the same strategy as the carve-outs with allocated cash, the firm must create a separate composite for the standalone portfolio(s) (3.A.18). As a result, it will not be uncommon for firms to have to two separate composites for the same strategy. The only difference between them would be that one includes standalone portfolios and the other includes carve-outs with allocated cash.
When calculating net-of-fee performance for carve-out segments, it will be important to determine the prospective investor and the target portfolio, whether it is a standalone portfolio or a multi-asset portfolio. GIPS 2020 requires the net-of-fee return calculation to be representative of the investment management fee that would be charged to a prospective investor. Furthermore, if actual fees are used, GIPS 2020 requires firms to allocate fees to each segment that are appropriate for each asset class (2.A.47).
How does this impact my presentation and disclosures?
GIPS 2020 further expanded upon the presentation and disclosure items required for composites that include carve-outs with allocated cash. Recalling from earlier, the 2005 edition of the GIPS Standards required firms to disclose the percentage of composites composed of carve-outs. Under GIPS 2020, the standards now specify that the percentage of composites must be presented only for carve-outs that allocate cash (4.A.6). As such, firms need not present the percentage of carve-outs that maintain separate cash accounts. The purpose of this was to provide a prospective investor with an idea of the portion of the composite not represented by a standalone portfolio.
To further drive home this point, GIPS 2020 requires composites including both carve-outs with allocated cash and standalone portfolios to present composite returns and asset market values of the standalone portfolios segment for each annual period end (4.A.13). As you might recall from earlier, composites will have already been created in connection with Provision 3.A.18 and as such, including the related returns and composite assets should be a relatively easy task.
Additional disclosures required by GIPS 2020 include indicating within the composite name that the composite includes carve-outs with allocated cash as well as disclosing that the GIPS composite report for the composite standalone portfolios is available upon request, if it exists (4.C.28).
Can I switch my accounts from cash account to allocation?
In response to the release of the new guidance on carve-outs, firms currently including carve-outs with segregated cash accounts may be enticed to start allocating cash to alleviate the administrative burden of tracking cash separately. For carve-outs already set up with a segregated cash account, it may be easier to continue tracking cash separately, but what about for new accounts? Is it possible for a composite to include carve-outs with segregated cash accounts, carve-outs with allocated cash, and potentially standalone portfolios?
Under GIPS 2020, both standalone portfolios and carve-outs with segregated cash accounts are treated one in the same, while carve-outs with allocated cash must adhere to all of the new requirements prescribed within the 2020 GIPS standards.
Inclusive of these requirements is the provision to create carve-outs with allocated cash from all portfolios and portfolio segments within the firm managed to the same strategy. As such, firms electing to allocate cash to carve-outs for a strategy that once included carve-outs with dedicated cash accounts will now need to allocate cash for all carve-outs managed to that strategy. This change should be made on a prospective basis and firms should not restate previously reported performance.
Furthermore, this change would qualify as a composite redefinition and firms must disclose the date and description of any composite redefinition. As a result of this requirement, we expect firms will create carve-outs with allocated cash for strategies where they don’t have carve-outs with segregated cash accounts.
Changes to the GIPS Standards involving carve-outs have certainly evolved over time. GIPS 2020 offers a new take on carve-outs to broaden acceptance of the standards, while also addressing the noted concerns. While allowing the allocation of cash to carve-outs will hopefully draw new firms to the GIPS Standards, the additional requirements will safeguard prospective investors from being misled.
Although a majority of the new guidance introduced by GIPS 2020 regarding the allocation of cash to carve-out have been covered throughout this article, it will be important to make sure all requirements are met when making the election to allocate cash to carve-outs. For more guidance about GIPS 2020 and to schedule a conversation, please contact us.
And, if you already claim compliance with GIPS, consider taking advantage of Kreischer Miller’s free GIPS initial assessment, which will:
- Identify potential issues and areas for improvement, and
- Provide meaningful feedback about your current process.