Performance standards

Performance Standards

Performance standards are established guidelines and principles used by financial firms and professionals to accurately calculate, present, and disclose investment results. These standards are crucial within the broader field of investment management, aiming to foster transparency, comparability, and integrity in financial reporting. Adhering to robust performance standards enables investors to conduct effective due diligence and make informed decisions by providing a consistent framework for evaluating the historical success of various investment strategies and vehicles.

History and Origin

The evolution of performance standards is deeply rooted in the need for accountability and comparability in the investment industry. Prior to the widespread adoption of formalized standards, investment performance reporting varied significantly among firms, making it difficult for investors to directly compare results or ascertain the veracity of advertised returns. Early efforts to standardize performance measurement emerged in the United States, notably with the Association for Investment Management and Research (AIMR) Performance Presentation Standards (AIMR-PPS) in 1993. These standards sought to bring uniformity to the presentation of investment performance.

Recognizing the need for a global framework, AIMR (which later became the CFA Institute) initiated the development of international standards in 1995. This collaborative effort culminated in the publication of the first edition of the Global Investment Performance Standards (GIPS) in 1999. The GIPS standards superseded the AIMR-PPS, becoming the internationally recognized ethical standard for calculating and presenting investment performance. This shift marked a significant moment in investment management, moving towards a unified approach that transcended geographical boundaries, as noted in academic discussions on the advancements in investment performance evaluation.¹⁰

Key Takeaways

• Performance standards provide a consistent framework for calculating and presenting investment results.
• The Global Investment Performance Standards (GGIPS), developed by the CFA Institute, are the most widely recognized voluntary ethical standards.
• Compliance with performance standards aims to ensure fair representation and full disclosure of investment performance.
• Regulatory bodies, such as the Securities and Exchange Commission (SEC), also impose rules on how performance is advertised.
• Adherence to these standards enhances investor confidence and facilitates meaningful comparisons among investment managers.

Interpreting Performance Standards

Interpreting performance standards involves understanding the intent behind the rules: to provide a complete and accurate picture of an investment firm's capabilities. For instance, the GIPS standards require firms to present a minimum of five years of GIPS-compliant performance history, building up to ten years, to prevent "cherry-picking" only the best performing periods. This requirement helps investors assess long-term trends and the consistency of returns.

Proper interpretation also requires an understanding of how different portfolios or strategies are grouped into "composites" for reporting. A composite is an aggregation of discretionary portfolios with similar investment objectives and strategies.⁹ This allows for a holistic view of a particular strategy's performance, rather than focusing on individual accounts. Investors should scrutinize disclosures accompanying performance presentations to understand the methodologies used, including how fees are deducted and how benchmarking is applied.

Hypothetical Example

Consider "Horizon Capital Management," an investment adviser that manages various client portfolios. To claim compliance with GIPS, Horizon Capital Management must define its "firm" consistently and include all fee-paying, discretionary portfolios in appropriate composites.

For example, let's say Horizon offers a "Global Equity Growth" strategy. To report performance for this strategy under GIPS, Horizon would group all client accounts managed under this specific strategy into a "Global Equity Growth Composite." They would then calculate time-weighted returns for each portfolio within the composite, aggregate these to the composite level, and present the performance net of fees, along with relevant disclosures. This ensures that a prospective client evaluating the "Global Equity Growth" strategy sees the collective, historical performance of all similar portfolios, rather than just a selection of the best-performing ones or gross returns that don't reflect actual investor experience. This rigorous approach supports accurate return on investment reporting.

Practical Applications

Performance standards are practically applied across various facets of the financial industry to ensure fair and transparent communication of investment results.

• Investment Firms: Asset managers and other investment firms adopt GIPS to demonstrate their commitment to ethical reporting and to gain credibility with institutional investors and consultants. Compliance with GIPS is often a prerequisite for competing for mandates from large pension funds, endowments, and foundations.⁸ It helps firms standardize their internal portfolio management and reporting processes.
• Marketing and Advertising: Regulatory bodies like the SEC impose specific rules on how investment performance can be advertised. The SEC's Marketing Rule, effective November 4, 2022, broadly defines "advertisement" and sets conditions for presenting performance information, including the requirement to present net performance alongside gross performance and performance data over specific periods.⁷,⁶ This rule significantly impacts how investment advisers communicate their results to prospective and current clients in the capital markets.
• Investor Protection: For individual and institutional investors, performance standards serve as a vital tool for protection. They enable investors to make "apples-to-apples" comparisons between different firms and strategies, reducing the risk of misleading performance claims. This enhances the overall integrity of the investment industry and aids in proper asset allocation decisions.

Limitations and Criticisms

While performance standards, particularly GIPS, aim to enhance transparency and comparability, they do have limitations and have faced certain criticisms.

One challenge is the voluntary nature of GIPS compliance; firms choose whether to adopt them. Although many institutional investors increasingly require GIPS compliance, not all firms adhere to them, which can still lead to inconsistencies in reporting across the broader market. Additionally, achieving and maintaining compliance with GIPS can be complex and resource-intensive, particularly for smaller firms or those managing highly specialized or alternative investments. Challenges often arise in data management, composite construction, and staying updated with revisions to the standards.⁵,⁴

Another critique revolves around the interpretation of certain provisions, especially when local regulations might conflict with the GIPS standards. While GIPS emphasizes adherence to the stricter of the two standards, navigating these nuances requires careful consideration and transparent disclosure.³ Despite these efforts, even with adherence to stringent performance standards, past performance is not indicative of future results, and firms cannot guarantee investment outcomes.

Performance Standards vs. Investment Performance Measurement

Performance standards refer to the codified rules and ethical guidelines that dictate how investment performance should be calculated, presented, and disclosed. They are the framework designed to ensure fair representation and full disclosure. The Global Investment Performance Standards (GIPS) are a prime example, providing a detailed set of principles for firms to follow in their financial reporting.

Investment performance measurement, on the other hand, is the process of quantifying the efficiency and effectiveness of an investment or portfolio. It involves the actual calculation of returns, risk-adjusted returns, and other metrics to evaluate how well an investment has performed over a specific period. While performance measurement is the analytical act, performance standards provide the methodology and rules for that act to ensure consistency and transparency. One could conduct investment performance measurement without adhering to formal standards, but the results might not be comparable or trustworthy across different entities.

FAQs

What are the Global Investment Performance Standards (GIPS)?
The GIPS are a set of voluntary, ethical standards for calculating and presenting investment performance, developed and maintained by the CFA Institute. Their purpose is to ensure fair representation and full disclosure of investment results globally.²

Why are performance standards important for investors?
Performance standards provide a consistent basis for investors to compare the historical performance of different investment firms and strategies. This helps investors make more informed decisions by ensuring that performance data is presented accurately and without misleading omissions.

Are performance standards mandatory?
The GIPS standards are voluntary ethical standards. However, many institutional investors require investment managers to be GIPS-compliant as a condition for doing business. Additionally, regulatory bodies like the SEC impose mandatory rules on how investment performance is advertised.

How do performance standards address risk?
While performance standards primarily focus on the calculation and presentation of returns, they often require disclosure of associated risks and may stipulate how risk-adjusted performance is presented. The goal is to provide a comprehensive view that includes both return and the level of risk management taken to achieve those returns.

Can a firm claim to be GIPS compliant if only some of its products meet the standards?
No. A firm must claim GIPS compliance for the entire firm and all its discretionary assets, not just individual products or composites. The GIPS standards require firms to define their "firm" clearly and consistently, and compliance applies to that entire defined entity.¹