Solutions for Hedge Fund Managers Considering the GIPS Standards
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Although the GIPS standards do not address the particular challenges of hedge funds, claiming compliance is possible and increasingly important for hedge funds. Creation of a client presentation, the process and frequency of portfolio valuation, and net performance stream calculation methodology are some of the issues hedge funds tackle in claiming compliance.
0. FUNDAMENTALS OF COMPLIANCE
Firm Definition. HFMs often have the misconception that compliance with GIPS standards can be achieved at the fund or product level. Rather, the GIPS standards require that a claim of compliance be made with respect to the entire firm, that is, all strategies and products that fall under the umbrella of the hedge fund management company. The firm should be defined in terms of how it is held out to the public; it can be a subsidiary of a larger financial services firm or a stand-alone business.
Providing a Compliant Presentation. One of the fundamental requirements of the GIPS standards is that a firm provide all prospective clients with a fully compliant presentation of the composite that is being marketed. This presentation must include all required disclosures and statistics found in Section 4 and Section 5 of the GIPS standards. Although this may seem initially like a daunting challenge for some HFMs, the construction of such a presentation is not an overly burdensome ordeal. Furthermore, this requirement does not mean that the HFM will have to completely revamp its marketing material. Rather, by including the fully compliant presentation as an appendix to the appropriate pitchbook, an HFM can easily satisfy the requirement that each prospect receive a copy of the presentation.
1. INPUT DATA
Portfolio Valuation. The GIPS standards require a firm to capture and maintain all data necessary to recreate account-level and composite-level performance. This data typically include market values of holdings as well as any external cash flows. At times, market valuations on some securities may be difficult to obtain. The GIPS standards do allow that “in the case of thinly traded securities, the firm may use a reasonable method for valuation as long as the method is consistently applied.”2 It is also important to note that the upcoming 2010 edition of the GIPS standards requires that firms utilize fair value as opposed to market value. This newest edition also includes the GIPS Valuation Principles, which is an instructive section meant to help firms adhere to the new fair value requirement.
Valuation Frequency. As of 1 January 2010, accounts are required to be valued on the date of any large, external cash flow (to be defined by the firm), and in the absence of a large, external cash flow, accounts are to be valued on a monthly basis. Because most HFMs only subscribe or redeem investors monthly (or, at times, quarterly), the possibility of a large, external cash flow occurring midmonth is almost zero. As a result, most HFMs are able to calculate a simple return for the month using the month-end net asset values, which are generated by the HFM’s third-party fund administrator.
2. CALCULATION METHODOLOGY
Net-of-Fee Performance Streams. Because most funds have such complexities as multiple share classes, feeders, and fee structures, generating a net performance stream for the fund typically requires considerable thought. This discussion will include three of the most common methods.
A. Tracking the Original, Full-Fee-Paying Investor. The most common method is to “present [a] return for [the] initial series of [the] highest paying share class, which reflects the net return of [an] investor in the fund since inception, assuming no subscriptions or redemptions.”3 The goal in using this method is to present a performance stream that is most representative of what a prospective investor would have achieved had he invested at the inception of the fund. It is important to note that this method is only appropriate when a fund is the only account in a composite. When a composite is composed of multiple accounts (the fund, separate accounts, etc.), the composite’s return needs to reflect the returns of all of its constituents.
B. Aggregate Approach. The aggregate method generates a return that reflects the performance of all assets in the fund, including all share classes, series, and fee structures. Although the product is a net return that includes all investors, it also is a return that no single investor has ever actually achieved. Furthermore, when a fund has different fee structures and investors with various high-water marks, the net return becomes a somewhat muddied mix of the various fees and produces a result that may not be particularly meaningful. This method is most appropriate when the fund is not the only account in the composite. When multiple accounts are in the composite, all of the accounts’ returns need to be asset weighted to achieve an aggregate return for the composite.
C. Model Fee. In the model fee method, the fund’s gross-of-fees return is simply reduced by the highest stated management fee and performance fee, which is typically done in a spreadsheet and is fairly straightforward. The primary advantage of this method is its ease of use, and its biggest drawback is that the net performance is calculated using an assumed fee. If a fund’s highest stated fees are greater than the fees that are actually charged, this method likely will result in net performance being understated. Regardless of which method is chosen, it is vital that the decision is well documented and disclosed in the composite’s compliant presentation.
3. COMPOSITE CONSTRUCTION
Composite construction is typically one of the easier sections of the GIPS standards for an HFM to comply with. The GIPS standards require that all accounts managed to the same objective or strategy be included in the same composite. Frequently, a hedge fund is the only account at the firm managed to a particular strategy, and when this is the case, the result is a single-account composite comprised solely of the fund. It is important to note that when an HFM has multiple accounts (hedge fund, private client account, pooled vehicle, etc.) managed to the same strategy, all of these accounts need to be included in the same composite.
4. DISCLOSURES / 5. PRESENTATION AND REPORTING
These two sections of the GIPS standards include the required disclosures and statistics that must be included in the firm’s compliant presentation, which was mentioned above. This compliant presentation is the document that allows perspective clients to make an apples-to-apples evaluation of the performance of different managers who are running the same strategy. For example, a prospect could compare a global macro strategy from a manager in San Francisco with a global macro strategy from a manager in London and have comfort in knowing that the presentations it is reviewing include the same required information.
Side Pockets. In certain instances, HFMs have chosen to make use of side pockets, which are a way to segregate illiquid securities from the rest of the fund (the liquid portion of the fund). When side pockets exist in a fund, there also exists the question of how to present the performance of the fund. Firms may choose to present a single performance stream, either of the liquid portion of the fund or of the track record of the total fund, which would include the impact of the side pocket. A firm also may present these two performance streams side by side. When determining which performance stream to present, a firm should analyze first its existing investor base to determine to what the majority of the existing investors are exposed. If only a select few investors have exposure to the side pocket, then it likely would be most appropriate to present the performance of the liquid portion of the fund. The overriding principle is to present a track record that is most representative of what a prospective client would have achieved. Regardless of which choice is made, it is critical that the firm document exactly what is being presented and the justification for that decision.
To conclude, the alternative asset management industry is in the midst of a rapid flight to transparency and claiming compliance with the GIPS standards is a step in that direction that many HFMs are taking. While formal guidance from the GIPS standards is forthcoming, claiming compliance is something that currently is possible and, in fact, much easier than many HFMs may think.
–Coleman C.J. McKinstry, CIPM, is with ACA Beacon Verification Services.
1. The comments and suggestions in this paper are not intended to replace or supersede any current or future formal or informal guidance issued by CFA Institute, which may differ from the views and opinions expressed herein. Nothing in this paper should be relied upon as advice for any particular set of facts, nor as a substitute for the guidance of a GIPS professional.
2. CFA Institute. Global Investment Performance Standards (GIPS) Handbook. Second Edition, 2nd ed. (Charlottesville: CFA Institute,2006):78.
3. Valerie Lamanna. “Applying the GIPS Standards to Hedge Fund and Other Alternative Strategies.” Presentation given at the GIPS Standards Annual 2007 Conference, Session VI, Chicago (27–28 September 2007):Slide 17.