CFA Level 1

Ethics and Standards - GIPS: Composites And Verification

What Are Composites?
Composites are single groups of discretionary portfolios that collectively represent a particular investment strategy or objective.

Composite Construction - Requirements
1. Actual, fee-paying, discretionary portfolios must be included in at least one composite. Non-fee-paying discretionary accounts may be included.

2. Nondiscretionary accounts must not be included in a composite.

3. Composites are defined based on a common investment objective or strategy. A full definition must be made available upon request.

4. New accounts are included in composites in a timely manner and one that is consistently applied, once the account comes under full discretionary management.

5. Terminated accounts must be included in the historical record up to the last full measurement period in which they were under management. In other words, there is no survivorship bias where terminated accounts are eliminated.

6. Accounts cannot be switched from one composite to another unless the client's objectives are documented to have changed, and the record of the portfolio remains in the appropriate composite.

7. Hybrid securities (e.g. convertibles) must be treated consistently within composites.

8. Carve-out segments (i.e. a single asset class that is carved out of a diversified portfolio - such as the returns on foreign stocks within a balanced account) must include a cash allocation that is consistently applied. Starting Jan 1, 2010, carve-out returns are not permitted unless the asset class is actually managed separately (with its own separate cash balance).

9. Composites must only include assets under management within the defined firm.

10. Simulated or model returns cannot be linked with actual performance.

11. If a minimum asset level is established, no account below that value can be included, and changes to the minimum level cannot be made retroactively.

Composite Construction - Recommendations
1.Carve-out returns should be excluded unless they are actually managed separately with their own cash balance (i.e. the standard that becomes mandatory in 2010).

2. To remove the effect of a significant cash flow, accounts receiving large external cash flows should use a temporary new account - in other words, place the amount of the deposit as if it were a new account but not part of the existing account. This method is an improvement versus simply excluding the account that received the deposit from composite calculations.

3.Firms are discouraged from marketing a composite with a minimum asset level to a client with assets below that level.

What is Verification?
The main purpose behind verification is to ensure that a firm that claims compliance with the GIPS has actually adhered faithfully to the intent of the standards. The verification process also serves to help performance-measurement teams better understand the details of the GIPS and whether all firm presentations have been consistent.

Verification is another case of a standard that is recommended but not absolutely required to comply with the GIPS. If a test question indicates that a firm has not yet undergone the verification process, it does not necessarily mean it is not complaint with GIPS, and indeed, it is within its right to claim compliance should it meet all other requirements.

A verification report must confirm two main issues:

1. Whether a firm has complied with all firm-wide composite construction requirements.
2. Whether processes and procedures are designed to calculate and present compliant performance results.

A verification report should come from a third-party source to ensure credibility, and cover a minimum of one year.

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