Performance excused

What Is Performance Excused?

Performance excused refers to specific circumstances under which certain investment results or periods may be treated distinctly in the context of investment performance reporting, particularly by investment managers adhering to industry standards or client agreements. This concept is integral to transparent investment management and falls under the broader category of Investment Performance Reporting. Rather than implying a complete waiver of responsibility for poor performance, it typically relates to conditions that justify modifying, excluding, or providing specific disclosures for particular performance data to ensure fair representation and prevent misleading conclusions.

In practice, performance excused often arises when external, uncontrollable events significantly impact an investment portfolio or when specific types of assets or accounts do not fit standard performance aggregation rules. Adherence to ethical guidelines and regulatory requirements, such as the Global Investment Performance Standards (GIPS) or the U.S. Securities and Exchange Commission (SEC) Marketing Rule, often defines how performance can be excused and presented to clients and prospective investors. This ensures that reported performance accurately reflects a manager's skill and decisions under specified conditions.

History and Origin

The concept of performance reporting, including the handling of unusual circumstances, has evolved significantly with the growth of the global investment industry. Before the late 20th century, there was considerable variability in how investment firms calculated and presented their performance, leading to inconsistencies and challenges for investors attempting to compare different managers. This lack of standardization created opportunities for "cherry-picking" the best-performing accounts or periods, presenting a potentially misleading picture of overall capabilities.

Recognizing the need for a uniform framework, the CFA Institute, a global association for investment management professionals, sponsored the development of the Global Investment Performance Standards (GIPS). The first GIPS standards were published in 1999, establishing a globally accepted approach for calculating and presenting investment performance.³⁷ The objective was to promote investor confidence by ensuring fair representation and full disclosure of investment results.³⁵, ³⁶ The GIPS standards have been continuously reviewed and updated to maintain relevance, with a significant revision taking effect in 2020.³³, ³⁴ These standards address how firms should handle various situations, including those where performance might be considered "excused" from standard aggregation or reporting due to non-discretionary assets, specific client mandates, or external events, all while upholding ethical principles.³²

Key Takeaways

• Performance excused refers to specific conditions under which investment results are presented or aggregated differently due to external factors or specific portfolio characteristics.
• It is primarily governed by industry standards like the Global Investment Performance Standards (GIPS) and regulatory guidelines, such as the SEC Marketing Rule.
• The goal is to ensure fair representation and full disclosure of an investment manager's performance, preventing misleading comparisons.
• Common scenarios include non-discretionary assets, significant cash flows, or unique client-imposed restrictions that alter the manager's ability to execute their standard strategy.

Interpreting Performance Excused

Interpreting performance where specific elements have been "excused" requires careful attention to the disclosures provided by the investment firm. When an investment manager reports performance, the goal is to provide a clear picture of how well their investment strategy has performed under their active portfolio management. If certain parts of the performance are excused, it typically means they are either excluded from a standard composite calculation or are presented with specific caveats to explain unique circumstances.

For example, accounts that are not managed on a discretionary basis—meaning the client, not the manager, primarily dictates investment decisions—are often "excused" from a firm's standard composites under GIPS. This is because the manager does not have full control over the asset allocation or security selection, and thus, their performance would not accurately reflect the firm's core strategy. Understanding these distinctions helps investors conduct proper due diligence and assess a manager's skill relative to their stated client objectives.

Hypothetical Example

Consider "Horizon Capital," an investment firm that manages several equity strategies. Horizon Capital claims compliance with the GIPS standards. One of their clients, "Tech Innovators Inc.," has an investment portfolio managed by Horizon Capital under a broad growth equity mandate. However, due to a unique internal policy, Tech Innovators Inc. mandates that 30% of their portfolio must always be held in a specific, low-yielding money market fund, regardless of Horizon Capital's usual cash management or equity allocation strategy.

When Horizon Capital calculates its performance for its "Growth Equity Composite" (a grouping of similar discretionary portfolios), the portion of Tech Innovators Inc.'s portfolio that is tied up in the mandated money market fund would be "performance excused" from the composite. This means that while Tech Innovators Inc. is a client, the 30% constrained portion of their assets is not included in the calculation of the Growth Equity Composite's return on investment. This allows Horizon Capital to present the performance of its true discretionary management without being penalized (or unfairly boosted) by client-imposed restrictions outside its control. The firm would still report the total performance for Tech Innovators Inc. separately, but the composite itself reflects only fully discretionary assets.

Practical Applications

Performance excused principles are vital in several areas of the financial industry, primarily in ensuring transparent and ethical reporting of investment results.

• Investment Performance Reporting: The most direct application is within the framework of the Global Investment Performance Standards (GIPS). GIPS requires firms to include all actual, fee-paying, discretionary portfolios in a composite. Thi³⁰, ³¹s prevents firms from "cherry-picking" only their best results. Performance may be "excused" from composite inclusion if a portfolio is non-discretionary (meaning the manager does not have full control over investment decisions), if it's a "carve-out" (a portion of a larger portfolio with specific restrictions), or if it's a simulated or model portfolio. The²⁷, ²⁸, ²⁹se are typically not included in composites because they don't reflect actual, discretionary management.
• Regulatory Compliance: Regulatory bodies, like the U.S. Securities and Exchange Commission (SEC), also provide guidance on how investment performance should be presented in advertisements. The SEC Marketing Rule, updated in 2020, specifies how investment advisers must present performance, particularly concerning "extracted performance" (performance of a subset of investments). If an adviser presents the gross performance of a specific investment or group of investments, they are generally required to also present the net performance of that same extracted portion with equal prominence. Thi²⁴, ²⁵, ²⁶s ensures that investors understand the impact of fees and expenses. While not "excusing" performance entirely, it mandates specific disclosures that contextualize partial performance presentations.
• Investment Policy Statement (IPS) Clauses: In certain client agreements, an IPS may include clauses that implicitly define scenarios where performance deviations might be "excused" or understood within a specific context. For instance, an IPS might outline the acceptable levels of deviation from a benchmark due to market volatility or client-specific liquidity needs, which, while not excusing underperformance, acknowledges factors outside the manager's typical control.

Fi²², ²³rms that adhere to GIPS demonstrate a commitment to ethical conduct and transparency, enhancing investor confidence. Mor²¹e than 1,700 organizations worldwide claim compliance with GIPS, including many of the top global asset managers.

##¹⁹, ²⁰ Limitations and Criticisms

While the concept of performance excused aims to provide clarity and fairness in performance reporting, it is not without limitations or potential for misuse if not rigorously applied. A primary criticism, particularly regarding the flexibility within standards like GIPS, is the potential for firms to interpret "discretionary" or "similar investment mandate" in a way that allows for the selective inclusion of portfolios that enhance reported returns. While GIPS explicitly prevents "cherry-picking" by requiring all actual, discretionary, fee-paying accounts to be included in composites, the¹⁷, ¹⁸ subjective nature of what constitutes "discretionary" can sometimes lead to differences in interpretation.

Another limitation can arise if disclosures regarding "excused" performance are not sufficiently clear or prominent. Even if a firm technically complies with standards, a retail investor might misinterpret a composite's performance if they do not fully grasp why certain assets or periods were excluded or treated separately. For instance, the SEC Marketing Rule mandates that any presentation of gross performance must also include net performance, calculated for the same period and with equal prominence, to prevent investors from overlooking the impact of fees. How¹⁵, ¹⁶ever, firms still need to ensure their overall presentation is not misleading.

Furthermore, legal doctrines concerning "excused performance" in general contract law (e.g., impossibility, impracticability, or frustration of purpose) provide a broader context, excusing parties from fulfilling contractual obligations under unforeseen and uncontrollable events. Whi¹², ¹³, ¹⁴le these doctrines protect against true impossibility, they are rarely invoked in routine investment management unless extraordinary events (e.g., natural disasters, regulatory prohibitions) genuinely prevent a manager from acting on behalf of a client, which is distinct from simply experiencing poor market performance. Courts evaluate claims of excused performance carefully, ensuring the event was unforeseeable and not within the party's control.

##¹⁰, ¹¹ Performance Excused vs. Performance Attribution

While both "performance excused" and "performance attribution" relate to how investment results are analyzed and presented, they serve distinct purposes in performance measurement.

Performance Excused focuses on the inclusion or exclusion of specific accounts, assets, or periods from standard composite performance calculations or the special treatment of certain data, typically due to client-imposed restrictions, non-discretionary management, or external factors that make standard inclusion inappropriate for fair representation. The intent is to define the boundaries of what truly reflects the manager's discretionary skill according to established reporting standards.

Performance Attribution, on the other hand, is an analytical technique used to explain why a portfolio's actual performance differed from its benchmark. It ⁹decomposes the difference (known as the active return) into various components, such as asset allocation decisions (choosing to over/underweight asset classes or sectors relative to the benchmark) and security selection decisions (choosing individual securities that outperform or underperform their benchmark counterparts). Per⁸formance attribution helps identify the sources of value added (or subtracted) by a portfolio manager. For example, it might show that a manager outperformed because of strong stock picks, even if their overall asset allocation was neutral.

In essence, performance excused defines what performance is being reported and how it's aggregated, whereas performance attribution explains why the reported performance (or deviation from a benchmark) occurred.

FAQs

What are the Global Investment Performance Standards (GIPS)?

The Global Investment Performance Standards (GIPS) are voluntary ethical standards for calculating and presenting investment performance, developed and maintained by the CFA Institute. The⁷y provide a standardized, globally accepted framework to ensure fair representation and full disclosure of investment results by firms.

##⁵, ⁶# Why would certain performance be "excused" from a firm's composite?
Performance might be "excused" from a firm's composite if the assets are not managed on a discretionary basis, meaning the investment manager does not have full control over the investment decisions. Oth⁴er reasons include significant client-imposed restrictions that prevent the manager from executing their standard strategy, or if the account is a "carve-out" that isn't truly representative of a standalone strategy. The³ goal is to accurately reflect the performance of portfolios where the manager has full control.

How does "performance excused" relate to regulatory compliance?

Regulatory bodies, such as the SEC, have rules governing how investment performance can be advertised. The SEC Marketing Rule requires that if an adviser presents "extracted performance" (performance of a subset of investments from a larger portfolio), they must also include the net performance of that subset alongside its gross performance with equal prominence. Thi¹, ²s ensures investors see the impact of fees and expenses, preventing a misleading portrayal of returns.

Does "performance excused" mean an investment manager is not responsible for losses?

No, "performance excused" in the context of investment performance reporting does not mean a manager is absolved of responsibility for losses. Instead, it refers to specific circumstances under which certain performance data is treated differently for reporting purposes to ensure transparency and fair representation. It's about how performance is presented and calculated under specific guidelines, not about excusing a lack of fiduciary duty or general underperformance.

Can an Investment Policy Statement (IPS) include clauses related to performance?

Yes, an Investment Policy Statement (IPS) typically outlines the client's risk tolerance, client objectives, and the investment strategy, and often includes guidelines for performance monitoring and review. While an IPS does not typically use the term "performance excused," it can define scenarios (e.g., specific asset allocations, liquidity constraints) that might lead to performance deviations outside a manager's control, providing a contextual basis for evaluating results.