Anyone with compliance or marketing & sales experience in the asset management business is likely familiar with “GIPS”, the Global Investment Performance Standards. This is a set of guidelines published under the auspices of the CFA Institute that governs things like performance, AUM and NAV reporting produced by asset managers. Think of it as GAAP for asset managers.
But despite the ubiquity of GIPS, many hedge funds have charged that it falls short in some areas and fails to adequately address the unique issues faced by hedge funds and structured products. As a result, the GIPS Executive Committee recently proposed a new “Guidance Statement on Alternative Investment Strategies and Structures” and is asking for your feedback.
It addresses a number of hot button topics for hedge funds (e.g. leverage, master-feeders, benchmarks, and performance fees). But you’ll notice a common theme to the entire document: Many of these issues have already been addressed by plain vanilla GIPS. In fact, the GIPS folks almost seem a little miffed that hedge funds have been whining all these years:
“While a firm that manages alternative investments has always been able to comply with the GIPS standards, there has been a perception that because the GIPS standards do not include guidance dedicated to such investments, that compliance was not possible…If a firm manages alternative investments, nothing precludes the firm from claiming compliance with the GIPS standards for those investments.”
In other words, just because you’re long-only fund throws on a few short positions, it’s not like you were in uncharted territory or anything. So, if you were making up your own rules along the way, time to think again. Long/short funds aren’t really that different from long-only funds and many unique aspects of alternative investments, such as their relative illiquidity, that were covered by previous GIPS standards governing private equity and real estate.
Still, the GIPS committee clearly wanted to highlight the point by restating many existing rules. For example, illiquid investments were already contemplated in previous “GIPS Valuation Principles” texts. According to the Alternative Investment guidelines, these existing rules also “incorporate various degrees of liquidity.” Further, GIPS already governs mark-to-model valuations. So it’s not like hedge funds with exotic strategies were being neglected.
Many view leverage as an issue very unique to hedge funds. But once again, the good folks at GIPS point out that previous guidance (The “Guidance Statement on Calculation Methodology”) should suffice.
Ditto for performance fees. Although many view these fees as the unique genetic marker of a true “hedge fund” (especially the SEC), the new alternative investment guidelines point out that existing GIPS standards already “define investment management fees to include both asset-based and performance-based fees.” In other words, existing guidelines are “equally applicable for alternative investment portfolios [sic].”
Funds of Funds
Perhaps one area that appears not to have been as well covered by previous GIPS guidelines is the quintessentially hedge fund-ish fund of funds. The new proposals cover situations where a fund of funds needs to estimate its own value since the value of its underlying hedge funds can often take weeks to arrive. The guidelines suggest the funds of funds either wait until they have the final NAVs from their underlying managers or go directly to the administrators of those funds to confirm early estimates.
Similarly, hedge fund master-feeder structures appear to pose some new GIPS questions. Where all the fees are charged at the feeder level, for example, the master fund returns need to be presented as gross-of-fees (even though they may not actually charge any fees).
GIPS was designed to govern the reporting of funds and of individual customized accounts (which can be aggregated into “composites” if the mandates are similar). The problem with hedge funds (and their managed account siblings) is that they are highly idiosyncratic. As a result, the guidelines acknowledge that a GIPS-compliant composite simply may not be possible for managers using hedge fund type strategies. Add to this the complexities raised above by master-feeder structures and hedge fund managers are likely to be left high and dry by exiting GIPS guidance. The new guidelines fill in some, but not all, of the gaps here.
Side pockets are another quintessentially hedge fund issue. But do you have report the returns of a side pocket to potential new investors in the main fund even if those investors would be precluded from the side pocket if they invested? The short answer is “yes,” according to the new guidelines:
“[S]ide pocket performance must be included in the performance of the entire pooled fund if the side pocket includes assets managed by the firm on a discretionary basis. In such a case, the performance that must be included in the composite is the performance generated by the pooled fund…The fact that future investors will not be participating in the performance of the side pocket is not a valid argument to exclude the side pocket from the pooled fund performance.”
Of course, if the side pocket is managed on a passive basis, then the manager can’t credit for the returns, and can’t count the side pocket in its overall AUM.
This is an area that truly bedevils hedge funds. In the long-only space, there’s a benchmark for pretty much everything. But as the new guidelines point out, “[T]he lack of proper benchmarks for alternative investment strategies is well known.”
Unfortunately, GIPS doesn’t provide much more than its heart-felt sympathies here, stating only that “firms should be guided by the ethical spirit of GIPS.” (The “ethical spirit” being a sort of reporting deity worshiped by compliance officers around the world.)
Finally, the new alternative investment guidelines acknowledge that “A manager of alternative investment strategies should also consider whether additional risk measures beyond those required by the GIPS standards should be presented.” While the document suggests a few such measures. It doesn’t say much more than “disclosing proper risk measures is crucial.”
And there’s the rub for alternative investments. Despite the best efforts of the GIPS Executive Committee, the idiosyncratic nature of hedge funds defies simple rule making. Although many aspects of alternative investments can be – and apparently are – contemplated by existing GIPS rules for traditional investments, hedge fund managers are on their own in many other areas – to be “guided by the ethical spirit of GIPS,” to use “a great degree of judgement” in off-shore issues, and to provide reporting “sufficient to identify risks” (whatever that means).