GIPS(R) compliant firms are required to include all actual (i.e., a REAL account, not a model), fee-paying (i.e., that the account pays fees, though this may change with GIPS 2010 to mandate the inclusion of non-fee paying accounts, too), discretionary accounts into at least one composite. Let us turn our attention to the word, "discretionary." What is meant by this?
First, the term is admittedly confusing. We are already aware of the legal definition: that is, a firm is legally discretionary if they have granted the portfolio manager the right to trade on their behalf. Great! Is that what we mean here? NO! Then what DO we mean?
We mean GIPS discretionary. In order to know if an account is discretionary from a GIPS perspective, it already has to be legally discretionary. And here we're speaking of the cases where accounts have placed certain restrictions on the manager (e.g., no "sin" stocks). The manager gets to decide if the restriction has impeded their ability to execute their strategy.
While teaching a class recently I came across this metaphor (or analogy, if you prefer), which I think may help. Let us turn our attention to the world of cooking.
For roughly 35 years I have had the responsibility to make the stuffing whenever we have turkey. And each year I turn to my wife's trusty Betty Crocker Cookbook for the recipe. And each time I prepare the stuffing, I do it the same way.
Now let's suppose that I've been asked to prepare the stuffing for someone else and they ask me to substitute wheat bread for the white bread, or perhaps to add a cup of chicken broth to the mix. Can I do this? Yes, of course. But, can I predict what the result will be? Am I comfortable taking the praise (or criticism) for the result? Maybe not. You've altered my normal recipe...my normal strategy for executing my process to prepare the stuffing. And so, I may say "yes, I can do this, but you get the credit for this idea." Thus, I might say that it's nondiscretionary.
Returning to investing, I wouldn't say that the client gets the credit. Clearly, I've agreed to do something for the client and the result is influenced by whatever that was. But, I may not feel that the result matches what would have occurred had I not had the adjustment made and thus declare it nondiscretionary for GIPS purposes.
Hope this helps! Please let me know your thoughts.
Subscribe to:
Post Comments (Atom)
.png)
I've always been pleased that the integrity of composites are upheld by providing guidance (not "rules") to ensure that all portfolios following a similar strategy are included in each composite. A key component of this process is allowing managers to exclude portfolios that do not represent the investment strategy because of client-imposed restrictions.
ReplyDeleteOn the other hand, I've always been confused by the unlimited degree of discretion given to managers in deciding for themselves which client restrictions prevent them from exercising their strategy. Frankly, without some guidance on what degree of discretion prevents a manager from implementing their strategy, we open the door to cherry-picking the best accounts for each composite. This is one of the more serious errors that we are trying to prevent!
Is there a requirement that managers explain which accounts were excluded and which client restrictions prevented them from exercising their strategy? Who needs yet another required disclosure? But without this, I wonder how we control the integrity of the composite inclusion process, which is the cornerstone of the integrity of the GIPS standards.
I'm ot
There is no such required disclosure and frankly I'm not sure I'd want to see one. Unfortunately, there are aspects of the standards that are geared to the "lowest common denominator." That is, to control firms that are prone to try to get away with whatever they can. Consequently, the more ethically minded firms (which I'd argue are the majority) have to pay a penalty to play the game.
ReplyDeleteAlthough there is no required disclosure, we do have the recommendation that firms be verified, and it's the verifier's role to look into the firm's definition of discretion, which should be in their Policies & Procedures document, and compare this with how the firm classifies accounts.
During the course of our verifications we routinely review the P&P and investigate the accounts that have been excluded because they've been classified as "non-discretionary" for GIPS purposes.
I think it's important to note that managers face a trade-off between composite assets and dispersion. So if a manager excludes too many accounts because they are deemed "non-discretionary" to keep dispersion low, composite assets will fall. If the manager is comfortable with this, then why shouldn't they be able to exclude the accounts?
ReplyDeleteOf course, if they are removing the worst performing accounts after the fact, that is fraud. I don't the a problem with there being rules set up ahead of time that are followed consistently.
Is my logic flawed?
Dispersion isn't a reason to define an account as being "non-discretionary." It may be a tool to identify issues that might in of themselves be reasons (e.g., if the client has restrictions which result in wide differences). Yes, the manager has this right, as long as they exercise it properly. There's some guidance on this, but the firm should look to their consultant or verifier for guidance, too.
ReplyDeleteI think you misunderstood; I apologize if I wasn't clear. Correct me if I'm wrong, but I can put accounts where I am restricted from selling legacy positions or where I can't sell stocks with a low cost basis into my composites if I so choose. The cost of those increased composite assets is higher dispersion (most likely - unless those positions always perform in-line with the strategy). If I want to tighten up dispersion, I can exclude these types of accounts. That is the trade off I was referring to.
ReplyDeleteI just want to make clear we are not using dispersion to define non-discretionary accounts.
Derek, I now understand. You are correct in that you have some flexibility to decide. If you feel that the restriction is such that you can live with it and that the resulting portfolio is felt to reflect your strategy, then you can include it. Yes, the manager has discretion over how they define discretion!
ReplyDelete