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Avoid Memorization and score points on GIPS for CFA L3



GIPS is long, boring, and likely to be tested. It usually comes up in an afternoon item set.

The material here is, in some respects at least, closely linked to Ethics in its philosophy of standardization and client-friendly practices. So while some questions can get very specific, when in doubt think about the guidelines for answering ethics questions, always go with the stricter standard, and think about the basic principles of what GIPS is trying to accomplish in terms of leveling the information playing field (and reducing the principal-agent problem).

Avoid Memorization and score points on GIPS for CFA L3

The rest of this post is about how to avoid 100+ pages of pure memorization from the CFA L3 curriculum. Skip the GIPS reading by lasering in on only the absolute key essentials that could get tested.

We'll start with the high level stuff and then move to the specific equations you are likely to see. 

First, a caveat—this post is by no means exhaustive.

That caveat aside, the material below should give you a GREAT start.

In fact, if you only remember the below you should still get 70%+ on the GIPS section.

Throw in a correct guess on a multiple choice question and you’ve earned a passing score on a small but tedious memorization intensive sub-section of the curriculum.

And that frees you up to spend your precious time on sections that are more important from an overall points perspective.

Key Characteristics of GIPS

  • Voluntary, minimum standards
  • Mix of requirements and recommendations, must be adhered to with the goal of full disclosure and fair representation (which likely requires going beyond the minimum GIPS requirements)
  • Only investment firms NOT individuals can claim compliance
  • Compliance must be on a firm-wide basis, NO partial compliance is allowed1
  • Full disclosure is mandated (no cherry-picking performance)
  • Composites must include ALL fee-paying, discretionary portfolios
  • It covers all asset classes
  • Data integrity is paramount to the process
  • Provides standards where regulated industry standards are still lacking
  • The GIPS is constantly evolving with standards getting STRICTER over time

Here’s how CFA L3 will test GIPS

We think the most likely GIPS questions would ask you to examine a GIPS return report and talk about factors presented or omitted that violate the GIPS requirements. The results will usually come in a table with the following column headers and then the elements listed below. Anything that is missing is a red-flag and should be IDed as not adhereing to GIPS.

 

Years

Composite return

Benchmark

# Portfolios

Internal Dispersion Measure

Amount of composite assets

Total Firm Assets or % of Total

 

Along with that information here’s the total summary of the items you need in a GIPS-compliant presentation:

  1. Correct GIPS compliance statement
  2. Definition of the firm
  3. Description of the composite
  4. Composite creation date and complete list of composites (available upon request)
  5. Policies for valuing portfolios, calculating performance, and preparing presentations (upon request)
  6. Currency use
  7. Description of benchmarks (or why there is none)
  8. Minimum of 5 years of returns and going up to 10
  9. ID whether net or gross fees
  10. Management fee schedule (upon request)
  11. 3 year ex-post standard deviation or another measure of internal dispersion and explanation

Reporting Requirements

  • Minimum of 5 years annual performance up to 10 years
  • Annual returns must be identified as gross or net-of-fees
  • Annual benchmark returns
  • # of portfolios in composite must be listed IF >5
  • Total amount of assets in a composite must be listed at end of each annual period
  • Total firm assets OR composite as a % of total assets at year end
  • If composite is
  • Measure of dispersion of individual portfolio returns (n/a for portfolios added to the composite during the period in question)
    • Could include range, interquartile range, high/low, standard deviation of annual returns

Post 2010 Reporting Requirements

  • Three years ex-post standard deviations must be shown using monthly returns for composite and benchmark. If management states standard deviation is inappropriate (like for a hedge fund) they must include a different ex-post risk measure
  • May link non GIPS compliant returns for periods before 2000 if they are disclosed
  • Must indicate the % of composite assets that are carve-outs, non-fee paying, and bundled-fee

From here let's break down some of the independent questions that could also show up.

Definition of the Firm

Because GIPS is mandated at a firm wide level with no partial compliance it is vital to understand how a firm is defined. Generally a firm is defined as “an investment firm, subsidiary, or division held out to clients or potential clients as a distinct business entity." 

A business entity is defined as a separate unit, division, or department that is organizationally or functionally separate from other units AND that has autonomy and discretion over the assets it manages and the investment decision making process.

 Signs a Division can be considered a Firm
  • It represents itself as such to clients
  • It depends on its own personnel, administration, and has its own resources/budget
  • It has a distinct investment process
  • Managers have discretion [read: autonomy] over the asset allocation process
  • It serves a distinct client base or market

Defining a discretionary portfolio

GIPS defines discretionary to include any assets that is not so constrained by the client that a manager can pursue its stated mandate. Discretionary assets also include assets managed by sub-advisors as long as the manager has discretion over choosing those sub-advisors.

Signs that a portfolio is NOT discretionary include:

  • Client has veto power over trades
  • Client frequently withdraws large amounts of cash
  • Client relationship is “advisory” only
  • The manager cannot change asset allocations or modify risk exposure

Building a Composite

When constructing a composite you must:

  • Include only AUM from within the defined firm
  • Cannot link to or include simulated or model portfolios
  • Must add new portfolios on a timely and consistent basis
  • Must include terminated portfolios up to the last full period (usually month) of inclusion
  • There is no switching of portfolios to other composites unless documented reasons exist (like a change in IPS or a redefinition of a composite). If it does move, its historical performance must remain as part of the old composite.
  • Post 2010 you cannot include carve outs unless that portfolio is truly separately managed with its own cash balance

All actual fee-paying discretionary portfolios must be included in at least one composite. Composites must be defined according to similar investment objectives and/or strategies, and must include all portfolios meeting that definition (again, you can’t cherry-pick).

Valuation Hierarchy 

The basic idea here is that some investments, particularly those that are illiquid etc, are difficult to value. So what do you do? Under GIPS you start with the most preferred level of valuation that meets all of the required objectives and if that is not available you move down the list using the other criteria.

Valuation Hierarchy

  1. Objective, observable, unadjusted market prices for similar investment in active markets
  2. Quoted prices for identical/similar investments in non-active markets
  3. Market-based inputs other than quoted or observable prices
  4. Subjective, unobservable inputs

Possible Calculations for GIPS on L3

Dietz and Modified Dietz

Both of these calculations refer to calculating overall portfolio returns.

The original Dietz calculation is designed to deal with cash flows in and out of a portfolio. It was permitted until 2005. It assumed that all cash flows occurred at the midpoint of the time period:

OriginalDietz=EMVBMVCFBMV+0.5CF\begin{array}{l}Original\;Dietz=\\frac{EMV-BMV-CF}{BMV+0.5CF}\end{array}

The modified Dietz method was used from 2005-2010. It weights each cash flow by the actual amount of time it was in the portfolio:

ModifiedDietz=EMVBMVCFBMV+(WiCF)\begin{array}{l}Modified\;Dietz=\\frac{EMV-BMV-CF}{BMV+\sum\left(W_i\ast CF\right)}\end{array}

Wheretheweight,Wi=Dayinperiod(CD)DayCFrecieved(Di)Dayinperiod(CD)\begin{array}{l}Where\;the\;weight,W_i=\\frac{Day\;in\;period\left(CD\right)-Day\;CF\;recieved\left(D_i\right)}{Day\;in\;period\left(CD\right)}\end{array}

Real Estate Return Calculations for GIPS

Real estate return calculations combine both an income component and a capital component such that Total Return = IR + CR. Both components of return are calculated using the amount of capital actually employed during a given period.

The total capital employed CE, is: CE=C0+i=1n(CFiWi)C_E=C_0+{\textstyle\sum_{i=1}^n}\left(CF_i\ast W_i\right)

In other words, it is the weighted average of the capital invested during the period.

Capital return component for Real Estate 

The Capital Return (RC) gives us the change in market value of a property (V) AFTER considering any capital improvement expenses (EC) and sale proceeds (S). It is calculated as:

CopitalReturn(RC)=V1V0EC+SCE\begin{array}{l}Copital\;Return\left(R_C\right)=\\frac{V_1-V_0-E_C+S}{C_E}\end{array}

Income return component for Real Estate 

The income return, RI, is the net investment income. In other words it is the income we earn through interest payments net of taxes, interest payments, and non-recoverable expenses such as leasing and maintenance. It is calculated as:

IncomeReturn(RI)=YAERIDTPCE\begin{array}{l}Income\;Return\left(R_I\right)=\\frac{Y_A-E_R-I_D-T_P}{C_E}\end{array}

Where:

YA = gross investment income

ER = nonrecoverable expenses

ID = Debt or interest payments

TP = property taxes

CE = capital employed

If you found this useful we have far more in-depth (but similarly focused) guided study notes covering every single LOS in the curriculum available on our site. In fact, sign up below and get immediate access to our free chapter covering GIPS. Our goal is to let you work smarter, not harder…and we think the price we’re charging is fair. See for yourself.