July 24, 2019
Ability to Once Again Allocate Cash to Carve-Outs
The 2020 edition of the Global Investment Performance Standards (GIPS®) was released by CFA Institute on June 30, 2019, and it includes a significant change with respect to carve-outs. Prior to January 1, 2010, firms were allowed to include carve-outs with allocated cash in composites. In the 2010 edition of the GIPS standards, the practice of allocating cash was no longer allowed. However, firms were allowed to include portions of broader accounts in composites as long as those accounts maintained their own cash balance. This provision limited many firms’ ability to market potential strategies and/or attain compliance with the GIPS standards due to system limitations.
With the 2020 edition of the GIPS standards, firms are once again able to synthetically allocate cash to carve-outs. It is believed that with this reinstated option more firms will be able to attain compliance with the GIPS standards. The 2020 GIPS standards define a carve-out as a portion of a portfolio that is by itself representative of a distinct investment strategy. For example, the equity portion of a balanced portfolio would be considered a carve-out. The use of carve-outs will give firms the ability to create track records for narrower strategies from accounts managed to broader strategies.
Provision 3.A.15. states that any carve-out included in a composite must include cash and that any related income and cash may be either accounted for separately or allocated synthetically to the carve-out on a timely and consistent basis. This means that carve-out portions of a broader strategy account can be set up in the firm’s system as their own accounts, either with or without cash. If the carve-outs do not have their own cash, a cash allocation can be calculated separately. The cash allocation method should be applied consistently to all accounts included in the composite. However, the 2020 GIPS standards do not require specific methods for allocating cash to carve-outs.
Provision 3.A.16 states that any carve-out included in a composite must be representative of a standalone portfolio managed or intended to be managed according to that strategy. An example would be a balanced account that includes a 50% allocation to US large cap equities. The large cap equities can be a carve-out from balanced accounts only if the US equity carve-out is representative of the way a standalone US equity account is managed or would be managed. However, creating an emerging market carve-out from a global equity account that has a few individual holdings in emerging markets would most likely not meet the requirement, as a fully invested emerging market strategy would hold more than a few issuers. The requirement for a carve-out to be representative of a standalone portfolio applies to all carve-outs and is not limited to carve-outs for which the firm allocates cash.
Provision 3.A.17 states that when the firm creates a carve-out of a particular strategy, allocates cash to the carve-out, and includes the carve-out in a composite, the firm must create carve-outs with allocated cash from all portfolios and portfolio segments within the firm managed to that strategy. The firm must also include those carve-outs with allocated cash in the composite. This prohibits firms from cherry picking selected carve-outs and allows a prospect to see the full universe of accounts managed in the strategy.
Provision 3.A.18 states that, when firms have or obtain standalone portfolios managed in the same strategy as the carve-outs with allocated cash, the firm must create a separate composite for the standalone portfolios. To follow with one of the examples above, this provision will require a firm to have a US Large Cap Equity Carve-Out Composite and a US Large Cap Equity Composite that includes only standalone accounts.
While the 2020 GIPS standards require the cash allocation method to be applied timely and consistently, they do not specify methods to be used to allocate cash. CFA Institute will be releasing explanations for each provision and it is expected to include recommendations for possible methods for allocating cash.
However, the 2020 GIPS standards do cover carve-out implications on net-of-fees return calculations. Provision 2.A.47. states that, when calculating net-of-fees returns of composites containing carve-outs, the management fee used for the carve-outs must be representative of the management fees charged, or that would be charged, to the prospective client.
Presentation and Reporting
If carve-outs with allocated cash are included in a composite, the GIPS Composite Report must:
When time-weighted returns are presented and the composite includes carve-outs with allocated cash, the firm must present the percentage of composite assets represented by carve-outs with allocated cash as of each annual period end. However, when money-weighted returns are presented and the composite includes carve-outs with allocated cash, the firm must present the percentage of composite assets represented by carve-outs with allocated cash as of the most recent annual period end.
Provision 4.A.13 addresses when the firm is presenting time-weighted returns for a composite that includes carve-outs with allocated cash and also has a composite of standalone accounts managed according to the same strategy. If so, the GIPS Composite Report for the composite that includes carve-outs with allocated cash must include the following information about the composite of standalone accounts:
The 2020 GIPS standards include an example of this scenario as Sample 5.
Similarly, provision 5.A.14 addresses when the firm presents money-weighted returns for a composite that includes carve-outs with allocated cash and also has a composite of standalone accounts managed according to the same strategy. If so, the GIPS Composite Report for the composite that includes carve-outs with allocated cash must include the following information about the composite of standalone accounts:
The 2020 edition of the GIPS standards has an effective date of January 1, 2020. GIPS Composite Reports and GIPS Pooled Fund reports that include performance for periods ending on or after December 31, 2020, must be prepared in accordance with the 2020 edition of the GIPS standards. Firms may choose to early adopt the 2020 GIPS standards. If firms choose to early adopt, they must comply with all requirements of the 2020 edition of the GIPS standards.