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Kreischer Miller Exhibiting at ICI General Membership Meeting
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Investment Company Institute
2013 General Membership Meeting
May 1-3, 2013
Marriott Wardman Park Hotel
Washington, DC
Sponsored by the Investment Company Institute, the General Membership Meeting provides a forum for industry executives to discuss key issues, feature industry leaders, and welcome international investment colleagues. Service providers and the press are important parts of each event.
Kreischer Miller will once again be exhibiting at this year’s ICI General Membership Meeting. Stop by and see us!
Investment Advisor Seeks Assistance with Becoming GIPS Compliant
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The Client
The Investment Advisor is a privately-owned investment management firm that follows a disciplined, value-based investment approach. The Investment Advisor’s principals have extensive experience in the investment management business and in managing the assets of high-net-worth individuals and institutions.
The Opportunity
As the Investment Advisor continued to grow its assets under management, new opportunities began to emerge. One such opportunity was to manage assets for a large high-net-worth client through a sponsor program. The sponsor had a rigorous set of criteria it used in selecting investment managers. These criteria included requiring the Investment Advisor to be GIPS compliant and to have the claim of GIPS compliance verified by a firm acceptable to the sponsor. At the time, the Investment Advisor was not GIPS compliant.
The Solution
In searching for a partner to help guide the Investment Advisor to GIPS compliance, they reached out to their investment industry contacts, which led them to Kreischer Miller. Having worked with other managers seeking GIPS compliance, we laid out an approach involving a pre-verification phase – which included an initial assessment of key issues and guidance on options for attaining GIPS compliance.
During the pre-verification phase, we utilized highly experienced directors and managers to gain a thorough understanding of the systems and controls in place. We met with the Investment Advisor to discuss the following:
- Composite construction and inclusion/exclusion policies
- The firm’s definition of discretion
- Existing policies and procedures and the requirements of the GIPS standards
- The systems used for portfolio accounting and composite maintenance
- Reconciliation processes
- The performance presentation creation process and required disclosures
- Other issues that needed attention and oversight
This pre-verification phase allowed the Investment Advisor to get immediate feedback on where it needed to focus in order to achieve GIPS compliance. As the firm worked on achieving GIPS compliance, we served as a resource to help guide it through the process. Many of the Investment Advisor’s internal procedures were tightened and additional checks and balances were implemented during the pre-verification phase.
The Outcome
After the pre-verification phase was complete, we performed a firm-wide verification. The Investment Advisor provided its GIPS verification report to the sponsor and won the large high-net-worth client.
GIPS compliance has become a requirement for investment firms to win new clients, especially for those investment firms that serve institutional and high-net-worth clients on sponsor platforms. Working with Kreischer Miller helped put the Investment Advisor in a position to compete for this type of business going forward.
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Investment Industry Guidance
What Investment Advisors Need to Know About 408(b)(2)
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In December 2007, a proposed rule was published concerning the disclosures that must be furnished to plan fiduciaries in order for plan services to be considered “reasonable.” Following a public comment period, public hearing, and interim final rule published in July 2010, the final rule became effective July 1. This regulation, Reasonable Contract or Arrangement Under Section 408(b)(2) – Fee Disclosure, which falls under 29 CFR Part 2550, affects pension plan sponsors, fiduciaries, and certain service providers, including investment advisers.
Scope
Under the rule, a “covered service provider” is any provider of certain services described in the rule that expects to receive $1,000 or more in compensation. Investment advisers are likely to fall into at least one of several categories, including, but not limited to, the following:
- Providing services directly to the plan — This would include “direct” investment advice, which causes the investment adviser to become a fiduciary under the Employee Retirement Income Security Act (ERISA).
- Providing services under the Investment Company Act of 1940 (’40 Act) or state law — This would include investment advice and also any other services covered by those regulations.
- Providing services and receiving “indirect” compensation — This would include advisory and consulting services, such as assistance with the implementation of investment policies or monitoring other plan service providers.
Requirements
- Disclosures in writing — Disclosures must be furnished to plan fiduciaries in writing.
- Description of services — Plan fiduciaries must have the basic information necessary to make informed decisions about the plan. In that regard, service providers are required to furnish a description of the services they reasonably expect to provide. Although no format for the information is included, the regulation specifies that it should be clear and understandable.
- Fiduciary status — Service providers are required to make a statement as to whether they will provide services directly to the plan as a fiduciary, or as to whether they will provide services to the plan under the ’40 Act, state law, or both. Investment advisers should be careful when making this statement in an agreement that includes both fiduciary and non-fiduciary (i.e. provider searches) services. From a risk-management perspective, it would be prudent to distinguish between those services.
- Compensation — Service providers must disclose both direct and indirect compensation. For direct compensation, the description can either be in the aggregate or by service and must include compensation that is paid directly from a participant’s account. In order for fiduciaries to analyze potential conflicts of interest, indirect compensation has additional requirements. The disclosure must include a breakdown of the services for which the indirect compensation will be received. Furthermore, the disclosure must include the payer as well as the arrangement between the payer and the service provider and the manner of receipt (i.e. billed, directly deducted).
To the extent compensation is determined on a transaction basis (i.e. commissions) or is charged directly against the plan’s investment and reflected in the NAV (i.e. 12b-1 fees), a description of that compensation, including the associated services, is also required for the provider, an affiliate, or a subcontractor. These disclosures are required regardless of whether they have already been disclosed in connection with the direct and indirect compensation disclosures above. Moreover, termination fees must be disclosed, including an indication of how any prepaid amounts will be calculated and refunded.
- Plan investments and investment options — Information about plan investments and investment options are required of fiduciaries to investment vehicles that hold plan assets and recordkeepers and brokers who facilitate the investment of the assets. Any changes to investment information must be made at least annually.
Disclosure errors
To the extent a service provider was acting in good faith and discloses the correct information to the fiduciary as soon as practical, not to exceed 30 days from the time the error is known to the covered service provider, inadvertent errors or omissions will not cause contracts to be prohibited transactions.
Timing
Initial disclosures must be provided to fiduciaries reasonably in advance of an arrangement. Changes to the required information must be provided as soon as practical, not to exceed 60 days from the time the change is known to the covered service provider. Because of the effective date, the initial annual disclosure must be provided no later than August 30, 2012. The first quarterly statement under the new rules must be provided no later than November 14, 2012.
In addition, to the extent a written request is made of a service provider, by a fiduciary, in relation to compensation, this must be provided by a service provider reasonably in advance of the date which the fiduciary indicates it must comply with its requirement. An example would be information needed to complete Form 5500, which is no later than 120 days after the end of the plan year.
Fiduciary exemption
Among various other requirements and notice provisions, fiduciaries have relief from the prohibited transaction provisions, so long as service providers are terminated for not disclosing information relating to future services within specified time periods.
An investment adviser may not suspect it is subject to the additional disclosures and requirements of this regulation. In addition, there are various other recordkeeping and compensation disclosures that may not necessarily apply to investment advisers but could be applicable to record keepers or firms dually registered as broker-dealers, and which have not been described in this article. It is important, even if the investment adviser’s only connection to retirement plans is through managed pooled funds, to review the regulation thoroughly and seek advice.
Craig B. Evans, Manager, Audit & Accounting can be reached at cevans@kmco.com or 215.441.4600.
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Manage Your Risks: How to Differentiate Between Investment Risk and Operational Risk
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This article originally appeared in Smart Business Philadelphia magazine.
A fundamental investing concept is that investors need to be compensated for taking on additional risk. However, investors often do not anticipate operational risks, and as a result, are often not compensated for them, says Todd E. Crouthamel, director, Audit & Accounting, at Kreischer Miller, Horsham, Pa.
“Operational risk can be difficult to price into the risk premium because human error is unpredictable,” says Crouthamel. “Therefore, many investors are left to assume that human errors will be prevented by the managers’ systems and controls, in order to rationalize hiring that manager. However, this is not always the case.”
Smart Business spoke with Crouthamel about how to differentiate between investment risk and operational risk.
What is investment risk?
Investment risk can be defined simply as the risk that the actual return on an investment will be lower than the investor’s expectations. Many investors are able to assess investment track records and investment models to decide if the potential rewards are worth the perceived risks in an investment. This type of risk is also readily measurable using various statistical measures, including:
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Alpha, the excess return of an investment relative to the return of the benchmark
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Beta, the measure of a volatility relative to the overall market
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R-squared, the measure that represents the percentage of an asset’s movement that can be explained by movements in the benchmark
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Standard deviation, the measure of the dispersion of data from its mean
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Sharpe ratio, which describes how much excess return is generated for extra volatility of holding an asset
What is operational risk?
The ratios described above are all built on certain assumptions, including that volatility equals risk. These ratios all derive risk measures based on quantitative factors; however, they do not consider qualitative factors, including the investment manager’s internal controls, design and implementation of its systems, and oversight of its employees. This is operational risk.
Human error makes operational risk unpredictable. Many investors may assume that human errors are prevented by the managers’ systems and controls, but that is not always the case. Consider the following situations:
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You hire Manager A to manage a large cap equity portfolio, and instead, Manager A finds better opportunities in the small caps and rationalizes investing your portfolio in small caps in the interest of earning you a better return. This guideline violation results in your portfolio being overweighted in small caps and minimizes your exposure to large caps.
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Manager B was recently examined by the Securities and Exchange Commission (SEC) and the SEC concluded that Manager B’s compliance program was wholly inadequate.
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Manager C has a trader with inappropriate access rights to override controls in the compliance system. The trader executes trades that are in violation of the investment guidelines and conceals these through the inappropriate access rights so these securities are not identified as investment guideline violations.
These examples are real. While some of these risks may be identified in the risk measures described previously, many go undetected until disaster strikes and losses pile up.
How can investors protect themselves from operational risk?
Elimination of operational risk is virtually impossible; however, it can be mitigated with some additional due diligence. Consider the following best practices:
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Review the Form ADV. If your investment manager is registered with the SEC, go to www.adviserinfo.sec.gov and read the adviser’s Form ADV, which consists of two parts. Part I provides details on the business, ownership, client base, employees, affiliations and disciplinary actions. Part II is a narrative that describes the services offered, fees, conflicts of interest and the backgrounds of management. Make sure that this information is consistent with what you already know about the adviser. If you are uncomfortable with any of the disclosures, make additional inquiries of the investment manager. If you are still not satisfied, consider another manager.
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Read the investment manager’s most recent SEC examination letter. The SEC conducts routine examinations of investment managers’ compliance systems and issues a letter detailing violations and enhancements that the investment manager should make. If your investment adviser is reluctant to share this letter with you, consider another manager who is more transparent.
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Make inquiries of the investment manager regarding its systems and internal controls surrounding compliance with investment guidelines. The compliance system should be automated, and overrides of transactions outside of the investment guidelines should require more than one sign off, preferably by someone who is independent of the trading and investment management process.
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Make inquiries of the investment manager regarding the financial strength of the company. An investment manager that is having financial difficulties may be more likely to take bigger risks.
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Read the investment manager’s report on internal controls. Many investment managers have a report that is prepared by an independent third party that tests various internal controls surrounding establishing new accounts, trading, reconciliation and accounting. This report generally details the testing performed and the results.
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If you are not confident in your ability to conduct operational due diligence, consider hiring a third party to conduct it on your behalf.
While these best practices may reduce your exposure to operational risks, there is no substitute for a healthy dose of skepticism. If an investment manager’s returns look too good to be true, they probably are.
Todd C. Crouthamel, Director, Audit & Accounting can be reached at tcrouthamel@kmco.com or 215.441.4600.
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Alternative to GIPS for Investment Performance Credibility
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Many investment advisors follow the Global Investment Performance Standards (GIPS) to bolster the credibility of their performance results. However, not all firms are able to claim compliance with GIPS. A non-GIPS examination report can add credibility to a firm’s performance results without the firm having to apply the GIPS standards to all of its assets under management.
Recognized as a voluntary global standard for calculating and presenting investment performance, GIPS are ethical principles that promote fair representation and full disclosure of investment performance. A firm complying with GIPS must apply the standards to all discretionary assets it manages. A firm can claim compliance with GIPS only after all of the required elements are met, including a presentation of at least five years of performance history (or since inception if the product is not at least 5 years old) for every composite. A firm’s GIPS compliance also can be audited by way of verification or a performance examination.
While the ability to demonstrate GIPS compliance can be advantageous for a firm, getting there can be difficult. What if a firm can bring only a portion of its products (i.e., one or two composites) into GIPS compliance? What if a firm is unable to get prior years into compliance?
Further complicating matters, many investment advisors manage assets for both institutional and individual clients. While implementing GIPS is typically more straightforward for institutional clients, it can be more challenging for individual investors. These personal portfolios often are highly customized to meet the investors’ individual needs. This can cause challenges in grouping accounts into similar composites, which is a fundamental GIPS requirement. In some cases, the use of sub-advisors or outside sponsor platforms can cause additional record-keeping and calculation concerns. While individual investor clients generally don’t inquire about GIPS compliance, in many cases, institutional investors require some type of assurance that the investment advisor’s investment performance is accurate.
So how can firms demonstrate credibility for their performance numbers when GIPS compliance isn’t an option? One way to solve this dilemma is to engage a CPA firm to perform a non-GIPS examination of the investment returns. In a GIPS verification or performance examination, the verifier’s report references the GIPS standards so the reader understands how the presentation works. However, it is possible to remove GIPS-specific references from the performance presentation and add disclosures that further explain the details of calculations and policies. Such a report would be similar to a GIPS compliant performance presentation.
A CPA firm can examine this non-GIPS presentation. The CPA’s opinion would indicate that they examined whether the performance was presented in accordance with the calculation methodology described in the notes to the performance presentation.
Investment advisors then can provide the CPA’s report to their investors and prospects to demonstrate the accuracy of the firm’s performance reporting, making the non-GIPS examination a great alternative for firms for which it is not practical or feasible to seek firm-wide GIPS compliance.
Thomas A. Peters, Director, Audit & Accounting can be reached at tpeters@kmco.com or 215.441.4600.
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