Composites: Identifying Eligible Portfolios and Establishing Investment Strategies

Defining Discretion

Let’s delve into the concept of defining discretion in managing portfolios. These restrictions on the investment process can vary widely, and they should be thoroughly outlined in the client’s Investment Policy Statement (IPS). While they serve as crucial risk management measures, too many constraints can limit the portfolio manager’s ability to execute their strategies effectively.

Now, when dealing with these constraints, there are two scenarios to consider:

• Non-Material Constraints: If the constraints are not considered material, the portfolio manager can include the portfolio in a composite alongside portfolios that don’t have such restrictions.
• Material Constraints: If the constraints are material, the manager may choose to include the portfolio in a composite with other similarly constrained portfolios. Alternatively, they may classify it as non-discretionary and exclude it from all composites.

Determining what constitutes ‘material’ constraints is at the discretion of each manager, but it should be reasonable. A key requirement in implementing the GIPS standards is having a clear, documented definition of discretion that is consistently applied by the firm.

In some cases, the pattern of external cash flows can render a portfolio non-discretionary. For instance, if a client frequently makes substantial withdrawals, potentially on a regular schedule, the portfolio manager might need to maintain a high level of liquidity. This situation could prevent them from fully implementing the investment strategy, unlike other portfolios with a similar stated investment mandate, objective, or strategy.

Model Portfolios

Model portfolios serve as replicas of an investment manager’s unique style and are employed to demonstrate their historical performance. It’s crucial to note that these model or hypothetical portfolios cannot be integrated into any composite. Instead, they are only allowed to be presented as supplementary information alongside the actual performance data. This separation between actual and model portfolios helps maintain the integrity and transparency of composite performance reporting, ensuring that investors receive accurate and reliable information regarding the manager’s real-world results.

Summarized Criteria for Composite Inclusion

• All actual, fee-paying, discretionary segregated accounts must be in at least one composite.
• Non-fee paying discretionary segregated accounts may be included in composites.
• Non-discretionary, simulated, or model portfolios cannot be part of any composite.
• Pooled funds must be included in a composite if they meet the composite’s definition.
• A composite must include all portfolios that meet its definition.

Composites – Defining Investment Strategy

To effectively define composites, firms can consider a hierarchical approach, which may involve the following levels:

• Investment Mandate: Start by categorizing portfolios based on their specific investment mandates or objectives.
• Asset Classes: Within each investment mandate, further classify portfolios based on the types of asset classes they primarily invest in.
• Style or Strategy: Dig deeper by identifying the particular investment style or strategy employed within each asset class.
• Benchmarks: Consider the benchmarks or indices used to measure performance in relation to the chosen style or strategy.
• Risk/Return Characteristics: Finally, assess portfolios based on their risk and return characteristics, taking into account factors such as volatility and potential for gains.

This hierarchical approach allows firms to systematically organize portfolios into composites, ensuring that each composite reflects a specific combination of investment criteria. It provides clarity and transparency in presenting performance data to clients and prospective investors, making it easier for them to evaluate how well a firm aligns with their investment objectives and preferences.

Defining Composites – Recommended Approach

Creating meaningful composites, a crucial aspect of implementing GIPS standards, can be challenging. Striking the right balance in the number of composites is essential. The following steps are recommended for defining composites effectively:

• Identify Distinctive Strategies: Begin by recognizing strategies that are easily distinguishable.
• Check Marketing Materials: Review the firm’s marketing materials to identify strategies offered as segregated accounts.
• Construct a Framework: Develop a framework with clear labels for potential composites.
• Assess Portfolio Fit: Considering client investment policies, assess how well fee-paying, discretionary portfolios align with the provisional framework.
• Ensure GIPS Compliance: Review the proposed composites to confirm they meet GIPS standards requirements.
• Document Definitions: Thoroughly document composite definitions and share them with relevant parties in the firm for final review.

This approach helps firms create composites that accurately represent their product offerings, ensuring compliance with GIPS standards while providing transparency to clients and investors.

Question

Which of the following is least likely to be a restriction that would render a portfolio non-discretionary?

1. Prohibition of sales of inherited assets.
2. Large frequent cash flows out of the portfolio.
3. Restriction on market-capitalization of underlying holdings.

Solution:

The correct answer is C.

Market Capitalization Restrictions:

Limitations based on market capitalization are merely style differences used for defining a composite. They do not render a portfolio non-discretionary but are considered when categorizing portfolios.

A is incorrect. Prohibition of Legacy Holdings: A ban on selling inherited assets can significantly impact an investment manager’s discretion. If a client’s portfolio mostly consists of legacy holdings they can’t sell, the manager’s ability to make decisions affecting the portfolio’s outcomes is restricted.

B is incorrect. Large Cash Flows: Significant outflows from a portfolio can complicate the performance assessment of a portfolio manager. These outflows obscure accurate evaluations of their performance under better conditions.