Best practice for composite construction

One of our GIPS(R) (Global Investment Performance Standards) verification clients called to ask what's the best practice for composite construction. Interesting question, I think.

We first touched on the meaning of "best practice," as it relates to the Standards, which is arguably an unknown, though I have concluded that it's what the Executive Committee thinks is best, which is fine by me; it's just important to know the context of the term. In the case of our conversation, though, I suspect the client meant what the industry might deem best, or best for ones clients or prospects.

If we turn briefly to the Standards, we know there are a host of recommended criteria available in the Composite Definition Guidance Statement. In reality, the standards afford the firm a great deal of latitude when it comes to construction. As is often stated, one can define their composites broadly, which allows more accounts to be included, with the likely result being more dispersion, or narrowly, meaning fewer accounts, with the anticipation of tighter dispersion.

Let's consider a brief example. Let's say that you have a U.S. large cap growth strategy, which you implement in two ways: with separate securities for your larger accounts, and mutual funds for your smaller ones. The "instruments used" can be a criteria for composite construction, and so you could have two composites: USLCG with separate securities and USLCG mutual funds. Or, you could combine them and have a single composite.

The advantages of a single composite are (a) more assets and (b) having to deal with just the single composite from a maintenance perspective; it also probably means wider dispersion. Going the dual composite route means tighter dispersion; it also means you'll have lower assets and have to work with two composites. Which is best practice? Well, if we're speaking from the standpoint of the firm it really depends on what they wish to accomplish. If you are disappointed that you'll have lower assets if you go with two composites, you can still show prospects the other composite, too, in order to demonstrate that your presence in that strategy is broader than one might conclude by looking at the single composite. From the prospect's perspective, to me it's clear that the dual composite approach makes more sense, because it means that they will see the one that aligns more accurately with their objectives and what you'll be doing for them. In the end, though, it's up to the firm. If you decide to have one large composite, then its description needs to indicate that mutual funds or (or possibly, "and/or") separate securities may be employed.

There are always trade-offs, and the firm gets to decide how they wish to deal with them. I was pleased that our client takes this so seriously, and wishes to do what is best for their prospects. It may mean more work for them, but it will allow them to better represent their success. There is more to be said on this topic, and we'll likely take it up again in the future. Your thoughts, ideas, and reactions are always invited.