As we draw near the December 31, 2020 adoption date for GIPS 2020, it will become increasingly important for firms to review the updated standards to determine whether any changes should be made, or more importantly, must be made to their existing policies and procedures to remain compliant.

While some of the changes and updates made in GIPS 2020 will result in the simplification of existing policies and procedures, others will require firms to assess, create, and adopt new ones altogether. We recommend that firms perform a gap analysis of their current policies and procedures in an effort to determine whether, at a minimum, all new requirements of GIPS 2020 have been met.

This article seeks to cover some of the changes and updates brought about as a result of GIPS 2020 that we anticipate will have an impact on many firms’ policies and procedures. It is important to note that this article is not meant to be all encompassing and, as a result, firms should review the updated standards in their entirety to understand the full impact of GIPS 2020.

Creating and Updating GIPS Reports

An area of the standards that has seen notable change, and is likely to impact a large number of firms, involves the creation and updating of GIPS reports. Before digging into these updates, it should be pointed out that GIPS 2020 replaced some keywords from the prior edition as well as introduced some new terminology that firms should take into consideration when updating their policies and procedures.

First and foremost, GIPS 2020 eliminates the use of GIPS compliant presentations and replaces it with GIPS reports. There are two distinct types of GIPS reports, each with their own set of requirements and recommendations. GIPS composite reports are more or less the same report one might associate with a GIPS compliant presentation. The GIPS pooled fund report is a new concept introduced by GIPS 2020 and is a presentation for a specific pooled fund.

In addition, GIPS 2020 introduces a model centered around portfolio types, which are then used as the basis for creating, updating, and distributing GIPS reports. As a result, firms will need to examine and segregate managed portfolios into one of three categories, each of which has been defined below:

• Segregated Account – a portfolio owned by a single client
• Broad Distribution Pooled Fund (BDPF) – a pooled fund that is regulated under a framework that would permit the general public to purchase or hold the pooled fund’s shares and is not exclusively offered in one-on-one presentations (i.e. mutual fund)
• Limited Distribution Pooled Fund (LDPF) – any pooled fund that is not a BDPF (i.e., hedge fund)

When creating composites, firms were previously required to include all actual fee-paying, discretionary accounts in at least one composite. However, under GIPS 2020, firms are now only required to include all actual, fee-paying segregated accounts in at least one composite. Pooled funds no longer need to be included in separate composites so long as the strategy is not offered for segregated accounts. As a result, previously kept pooled fund composites, often referred to as single-member composites, may be terminated. If the same strategy is offered for both pooled funds and segregated accounts, GIPS 2020 requires firms to include the pooled fund as part of the composite strategy. Furthermore, firms are prohibited from excluding one from the other based on legal structure alone.

Firms are required to create and maintain a GIPS Composite report for each composite strategy and a GIPS Pooled Fund report for each LDPF. Due to the complexities and regulatory requirements surrounding BDPFs, GIPS 2020 does not require firms to create and maintain GIPS Pooled Fund reports for BDPFs. While not required to do so, firms are not prohibited from creating a GIPS Pooled Fund report for a BDPF or including a BDPF in a GIPS Composite report. As indicated in the aforementioned paragraph, firms are required to include a BDPF in a composite if it meets the definition of a composite maintained for segregated accounts.

When updating GIPS Reports for distribution under the new standards, firms are now required to update reports to include information through the most recent annual period end within 12 months of that annual period end. In other words, when presenting calendar year-end periods, a firm must present the December 31, 2020 year-end returns no later than December 31, 2021. While most firms’ policies and procedures may stipulate that GIPS reports are to be updated at least annually, failure to do so now has the potential to jeopardize a firm’s compliance.

Distribution of GIPS Reports

The introduction of the portfolio type model brought about by GIPS 2020 resulted in changes made to the requirements governing the distribution of GIPS reports to prospects. The term “prospective clients,” for instance, was bifurcated into prospective clients and prospective investors. While a prospective client still represents any person or entity interested in one of a firm’s composite strategies, a prospective investor represents any person or entity interested in one of the firm’s pooled funds.

As it relates to the distribution of GIPS reports to prospective investors, differences exist in the requirements for BDPFs and LDPFs. Similar to composite strategies for prospective clients, prospective investors interested in LDPFs must be provided with an updated GIPS composite or GIPS pooled fund report at least once every 12 months. When providing a GIPS report to a prospective LDPF investor, firms have the option of providing either a GIPS pooled fund report or a GIPS composite report so long as the pooled fund is included within the composite. Firms are not required to distribute GIPS reports to prospective investors interested in BDPFs as a result of the nature of the investment and the availability of information.

One of the more important changes related to the distribution of GIPS reports is the requirement for a firm to demonstrate that it made every reasonable effort to provide GIPS reports to prospective clients and investors. This may require firms to develop more robust policies and procedures surrounding the tracking of such distribution. Sound policies and procedures should provide firms with pertinent information such as when a party initially became a prospective client or investor, which GIPS report was last provided, and when the next report is required to be provided. It should be emphasized that new verification requirements require verifiers to test this area as part of procedures performed. As such, it will be important to have tracking policies and procedures in place going into 2021.

Firm Assets

As part of the presentation requirements under the 2010 GIPS Standards, firms had the choice of presenting either total firm assets or composite assets as a percentage of total firm assets, as of each annual period end. GIPS 2020 removes that election and requires that all firms present total firm assets as of each period end. It is important to note that firms that have historically presented composite assets as a percentage of total firm assets need not retroactively update GIPS reports, as this option is still permissible for periods ending prior to December 31, 2020.

While not specifically addressed within the 2010 edition of the GIPS standards, firms previously relied on the guidance provided within the Guidance Statement on the Use of Supplemental Information when presenting advisory-only assets. GIPS 2020 specifically provides guidance on the use of advisory-only assets within GIPS reports. When presenting advisory-only assets, firms have the option to present amounts separately from total firm assets or combined with total firm assets, but presented as a separate value. Regardless of the decision, firms are still required to present total firm assets as a separate and identifiable value. It is worth mentioning that the presentation of advisory-only assets pertains to both firm-level assets as well as composite-level assets.

Non-Fee-Paying Portfolios

When opting to include non-fee-paying portfolios in a composite, firms were previously required to present the amount of composite assets represented by the non-fee-paying assets. However, under GIPS 2020, firms are no longer required to present this measure when presenting gross-of-fee returns or net-of-fee returns with a model net down. Only when presenting net-of-fee returns where returns are reduced by actual management fees charged (which would exclude non-fee-paying portfolios) are firms required to present this figure.

Portability

Historically, policies and procedures on the topic of portability have been relatively straightforward – if the new or acquiring firm met the prescribed criteria, performance of the past firm was required to be linked. However, under GIPS 2020, firms may choose whether to link past performance. The criteria for portability remained consistent between editions, with the exception of an additional criterion clarifying that the track record between the past firm and the new or acquiring firm be continuous in nature, if the firm wishes to link performance. If a break in performance does exist, firms are still permitted to port historical performance of the past firm, but are restricted from linking this to current performance.

GIPS 2020 also offers some clarity surrounding the timing and transition associated with the acquisition of another firm or merger of two firms. When a firm acquires another firm or affiliation, the firm has one year to bring any non-compliant assets into compliance. Furthermore, assets of the acquired non-compliant firm must meet all requirements of the GIPS standards within one year of the acquisition date, on a going forward basis. It’s worth reiterating that the one-year grace period applies to non-compliant assets becoming compliant on a prospective basis. New or acquiring firms are not required to bring past performance into compliance unless they want to port the prior track record, in which case there is no time limit or constraint.

Wrap Composites and Estimated Transaction Costs

In the past, wrap-specific composites or composites containing wrap portfolios posed a problem for firms in that transaction costs were indeterminable. This made it difficult to calculate and present gross-of-fee returns. Oftentimes, firms resorted to presenting a combination of net-of-fee returns in addition to other supplemental information, such as pure gross-of-fee returns.

As part of GIPS 2020, firms are provided the ability to estimate transaction costs when, and only when, actual transaction costs are unknown. Included within the Explanations of the Provisions in Section 2 put out by the CFA Institute, reasonable approaches to estimating transaction costs include using actual transaction costs for portfolios that the firm manages in the same or similar strategy, or actual transaction costs for similar securities that trade in a similar market. Estimated transaction costs may take the form of a percentage or as a monetary value. Regardless of the methodology selected, it will be imperative for firms to have clear policies surrounding the calculation of the estimated transaction costs as well as procedures for maintaining proper supporting documentation.

GIPS 2020 has introduced numerous changes to improve the standards. The CFA Institute has issued an Explanation of the Provisions for each of the sections within the standards, which provides firms with additional practical guidance to help implement the GIPS Standards. While we have offered this as a summary of changes potentially impacting your GIPS policies and procedures, it will be important to understand how to implement these policies in your organization. For more guidance about changes to the standards potentially impacting your policies and procedures, or any other part of GIPS 2020, please contact us.

We would be pleased to provide further information related to this subject. For more information, contact Joshua E. Kramer, Manager, Audit & Accounting at jkramer@kmco.com. 

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Overview of the Rules Under GIPS 2020

The error correction rules for firms are in provision 1.A.20 of GIPS 2020, which notes that firms must correct material errors in GIPS composite reports and must:

1. Provide the corrected GIPS composite report to the current verifier
2. Provide the corrected GIPS composite report to current clients and any former verifiers that received the GIPS composite report that had the material error
3. Make every reasonable effort to provide the corrected GIPS composite report to all current prospective clients and prospective investors that received the GIPS composite report that had the material error. The firm is not required to provide a corrected GIPS composite report to former clients, former investors, former prospective clients, or former prospective investors.

The rules for pooled fund reports mirror those for composite reports and can be found in Provision 1.A.21.

This provision seems pretty straightforward, except for one item. How does a firm determine if an error is material or not?

What’s Material?

In order to help explain the GIPS Standards, in the past the CFA Institute has issued GIPS Handbooks, which provide guidance and examples. Under GIPS 2020 for firms, the Handbook has been renamed Explanations of the Provisions. Many people still refer to this as the Handbook, and we will too in this article.

In the GIPS 2020 Handbook (or just Handbook for short), error correction and materiality guidance is presented for provisions 1.A.20 and 21. The Handbook also notes that an error, which can be qualitative or quantitative, is any component of a GIPS report that is missing or inaccurate.

In order to determine whether an error is material, the Handbook goes on to note that firms should start with the following:

Materiality Definition

An error (or item) is material if the magnitude of the omission or misstatement of performance information, in light of surrounding circumstances, makes it probable that the judgment of a reasonable person relying on the information would have been changed by the omission or misstatement.

This is a good definition as it gets to the crux of the matter whether or not the judgment of a reasonable person relying on the information would have been changed. This definition is consistent with the framework used in the accounting profession as well as frameworks used when weighing legal and SEC matters. Although quantitative measures are important, note that this is not a purely quantitative model and that judgment (qualitative analysis) is required in order to make a final determination.

We suggest that firms expand upon this materiality definition to create a framework. This can be done by adding the following:

Users

Materiality is influenced by the perception of the needs of GIPS report users who rely on those reports to make judgments about an investment manager’s performance. Users are viewed as a group, not as specific individuals.

Judgment Influence

In determining if an error could influence the judgment of a user (as defined above), users are assumed to:

• Have an appropriate knowledge of business and economic activities and performance reporting and a willingness to study the information in the GIPS reports with an appropriate degree of diligence;
• Understand that GIPS reports are prepared to levels of materiality;
• Recognize the differences in different methods for calculating and reporting performance;
• Make appropriate decisions on the basis of information in the GIPS reports.

Perspective of Materiality

Materiality considerations should include the entire GIPS report, rather than one line, number, or disclosure viewed in isolation. In addition, errors need to be evaluated along with other known errors (including uncorrected errors from prior periods). This article discusses this further below.

Quantitative and Qualitative Considerations

Although materiality is commonly expressed in quantitative terms, determination of materiality is a matter of professional judgment that includes both quantitative and qualitative considerations.

Why Can’t Materiality Just Be Quantitative?

We see a wide variety of approaches to materiality in practice, including some firms which adhere to simple numerical thresholds without taking into consideration context, multiple errors in one statement, non-numerical errors, and other concerns which require judgment.

When defining materiality, firms should consider many factors. Setting a single basis point limit (such as 20 basis points) as the sole determinant of materiality can be dangerous.

Materiality is a relative concept. For example, 20 basis points may be material on a return of 25 basis points; however, on a returns of 700 basis points, 20 basis points does not seem as significant. Also, such absolute factors are impossible to apply to all non-return figures and disclosures in a presentation.

Below we have listed several different types of errors. Many of the errors are the same quantitatively, but the reasons for the errors and impact on a presentation are different for each example. Is each error material or immaterial? These potential error scenarios illustrate that there are many types of issues that can trigger errors, and that a fixed, absolute definition of materiality is not flexible enough to effectively evaluate all potential errors and the impact to the users of a performance presentation. A relative framework, which involves judgment, is needed.

1. The composite return is off by 19 basis points.
2. The composite return is overstated by 19 basis points and correcting the difference would cause the manager to go from outperforming the benchmark to underperforming the benchmark.
3. The composite return is overstated by 19 basis points while the index return is understated by 19 basis points.
4. Every number on the presentation is 100 percent correct, but the notes are misleading.
5. The current year composite return is overstated by 19 basis points. Suppose every prior year composite return in the presentation has the same misstatement.
6. The composite return was overstated by 19 basis points to manipulate company bonus allocations to portfolio managers.
7. The composite return is off 19 basis points as a result of mispricing of the underlying securities; this caused the account to trigger a performance fee. Without the mispricings the account would not trigger the performance fee.
8. A U.S. manager’s composite presentation containing mutual funds only shows gross returns and the investment manager is registered with the SEC. All returns presented are correct, the presentation contains the required disclosures, but the SEC requirement to show net returns for composites containing mutual funds has been violated.

Bringing It All Together

We suggest that firms consider the following approach in evaluating whether errors are material.

1. Set quantitative thresholds and qualitative factors that trigger an error review. Trigger criteria don’t necessarily mean that an error is material. Rather, trigger criteria causes a review of the error by the firm. Trigger criteria might include:
   1. Returns off by more than X%
   2. Benchmark returns off by more than X%
   3. Dispersion off by more than X%
   4. When composite or fund AUM is off by more than X%
   5. When firm AUM is off by more than X%
   6. Number of accounts is off by more than X%
   7. Incorrect or missing disclosures
   8. Any other error or combination or errors that the performance team believes should be evaluated for materiality
2. Create a committee responsible for evaluating error materiality. Consider including the following team members on the committee:
   1. Performance professionals who are familiar with the GIPS Standards.
   2. Compliance professionals who are familiar with regulatory requirements and rules, such as those promulgated by the SEC.
   3. Investment professionals who understand the investment products being represented by the GIPS reports.
3. Use the materiality framework noted above to evaluate the errors. This might include the following:
   1. Recalculate the returns and quantify the error in the GIPS report. Any additional errors (including those from prior years that are still uncorrected) should be included in the analysis. The result is that the committee should be able to look at the current GIPS report with all errors identified. Maybe this is just one return. Maybe it’s the past 5 years’ returns and benchmark data. The point is to view the GIPS report as a whole when determining whether it’s misleading. Just analyzing one number, viewed in isolation, is generally not an effective method for determining whether the GIPS report is materially misstated. It is generally helpful to analyze errors both individually and in the aggregate.
   2. Determine if the error(s) are material based on the materiality definition and framework presented earlier in this article.
      1. For numeric errors, consider evaluating the error on both an absolute and relative basis. For example, 20 basis points may be material on a return of 25 basis points; however, on a returns of 700 basis points, 20 basis points does not seem as significant.
      2. For disclosure items (such as missing or incomplete disclosures), consider the impact of the error on a user of the GIPS report. Perhaps omitting a disclosure that indicates that the returns are calculated in USD is deemed to be immaterial, while omitting the required composite description is material.
4. Document the committee’s decisions and reasoning.
5. Follow the firm’s error correction policies:
   1. For material errors – the firm’s policies must follow the correction and distribution requirements of Provisions 1.A.20 and 21, including the redistribution of corrected reports to verifiers, clients, and prospective clients and investors who received the GIPS report that contained the material error. Also, the GIPS Standards require firms to disclose errors deemed material for a minimum of one year in the related GIPS report.
   2. For immaterial errors – the firm has more flexibility on whether to correct or leave the error uncorrected. Some firms do not make any changes under the rationale that it’s simply not material. Other firms correct the presentations. The key is to follow the firm’s policies and procedures consistently.
6. Maintain a log, which should include:
   1. A description of each error.
   2. Whether or not it was material.
   3. For material errors, to whom the corrected GIPS reports were sent.
   4. Any new policies and procedures implemented in order to minimize the risk of similar errors occurring in the future.

GIPS 2020 has introduced numerous changes to improve the standards. The Handbook provides additional practical guidance to help firms implement the GIPS Standards. While we have offered this overview of error correction and materiality determination, it is important to understand how to implement these policies in your organization. For more guidance about error correction, materiality, or any other part of GIPS 2020, please ccontact us.

We would be pleased to provide further information related to this subject. For more information, contact Thomas A. Peters, Director, Audit & Accounting at tpeters@kmco.com.

You may also like:

• The Top 5 Things You Need to Know About GIPS 2020
• GIPS Compliance Services for Investment Managers
• Free GIPS Initial Assessment