June 13, 2019
Composite Minimums: Common Issues
Firms have the option to specify a minimum size for composite inclusion. The purpose for establishing a composite minimum is to help define discretion, i.e., a firm feels it needs assets of a certain size to be able to fully implement the strategy. Since these composite minimums are tied to discretion, they may be composite specific. This could mean that only some composites have a minimum established. It may be the case that composite minimums make sense for certain asset classes, but not for others.
An example would be a firm that establishes composite minimums for its fixed income composites but not for its equity composites. Firms must disclose composite minimums, and this is often included in the composite’s strategy description.
It is best practice for firms with composite minimums to establish policies and procedures to review, by composite, portfolio market values to ensure they exceed composite minimums on a monthly basis. The process should then include a review of the portfolios identified as not meeting the composite minimum to determine whether their removal from the composite is appropriate based on the firm’s established policy.
Some potential concerns and issues include:
1. Composite minimums are not the same as marketing minimums. A firm may choose to not market to prospects below a certain portfolio size, but this is a separate decision from establishing composite minimums.
2. Firms should not market a composite that has a composite minimum to a prospective client if the firm knows that the prospect has less money to invest than the composite minimum. It would potentially be considered misleading to present performance for a strategy that is not available to the prospect. Firms should carefully consider the minimums to ensure they are not limiting the firm’s ability to market the composite.
3. Composite minimums must be consistently applied and may only be changed prospectively. Portfolios under the minimum size cannot not be included in the composite. A firm may set a simple policy for composite minimums, whereby a portfolio that falls below the minimum is removed from the composite.
4. Firms can establish composite minimum policies that differentiate portfolio decreases due to market depreciation versus client withdrawals. Applying such a policy can be challenging when a portfolio has cash withdrawals during the same period.
5. Establishing elaborate composite minimum policies can be manually intensive and, as a result, may lead to errors. It is not uncommon for firms with minimums to set bands around the threshold. Possible policies include:
Scenario 1
| Policy: Composite minimums $1M. Accounts are removed from the composite if the portfolio’s end of month value falls more than 5% below the composite minimum. | ||
|---|---|---|
| Application: If the portfolio’s ending value is $950,000 or less, then the account is removed from the composite, prospectively. | ||
| Date | Portfolio ending value | Include or Exclude? |
| 3/31/18 | $1,010,000 | Include |
| 4/30/18 | $980,000 | Include |
| 5/31/18 | $948,000 | Exclude beginning 6/1/18 |
Scenario 2
| Policy: Composite minimums $1M. Accounts are removed from the composite if the portfolio’s end of month value falls more than 5% below the composite minimum and stays below the minimum by more than 5% for a full two months. This means the account is removed after the third month below the initial decrease below the composite minimum. | ||
|---|---|---|
| Application: If the portfolio’s ending value is $950,000 or less for 3 full months, then the account is removed from the composite, prospectively. | ||
| Date | Portfolio ending value | Include or Exclude? |
| 3/31/18 | $1,010,000 | Include |
| 4/30/18 | $948,000 | Include |
| 5/31/18 | $949,000 | Include |
| 6/30/18 | $947,000 | Exclude beginning 7/1/18 |
All of these policies need to be applied consistently. However, if a firm has different policies for each composite, then the manual oversight can be quite complicated and labor intensive. As with any layered or manual process, the risk of error is greater.
6. Composite minimum changes must be disclosed. Firms that continually change minimums will need to disclose every minimum that was in place over the time period presented in the compliant presentation, leading to a lengthy disclosure.
7. With composite minimums, a very real possibility exists that a track record is broken if all portfolios drop below the minimum. The risk is greater if a composite has only a few portfolios.
8. There may be instances where composite minimums were established at the composite’s inception and many years later these minimums no longer have a meaningful impact on discretion. Policies should be established to ensure firms review composite minimums over time to confirm they are still applicable.
