Firm in Investment
In the field of investment, a firm is typically an investment firm, a subsidiary, or a division that is showcased to the public as a separate business entity. This distinct business entity could be a unit, division, department, or office that is organizationally and functionally segregated from other units. It maintains discretion over the assets it manages and should have autonomy over the investment decision-making process.
Identifying a Distinct Business Entity
Several criteria can be used to identify a distinct business entity. These include the organization being a legal entity, catering to a distinct market or client type, or employing a separate and distinct investment process. The way the investment management organization is presented to the public plays a crucial role in defining the firm.
For example, consider a division of a larger corporation that specializes in offering investment management services to private clients. If this division is marketed as an expert in catering to the investment needs of high-net-worth individuals and family offices, it might qualify as a “firm” for the purpose of compliance with the Global Investment Performance Standards (GIPS).
However, this division’s entitlement to be considered a firm under the GIPS standards could be justified if it were also incorporated as a subsidiary, had its own dedicated financial analysts, portfolio managers, and traders located in a separate building or area of the company, and reported through a separate chain of command to the parent organization’s senior management.
Implications of Defining a Firm
Given the complexity of modern organizational structures, it may require judgment to determine if a given unit properly meets the definition of a firm. This decision has immediate and lasting practical consequences. Because the GIPS standards apply firm-wide, the definition of the firm will determine the extent of the initial implementation and ongoing compliance activities.
It also establishes the boundaries for determining total firm assets. The term total firm assets refers to the aggregate fair value of all assets (whether or not discretionary or fee-paying) for which a firm has investment management responsibility. Total firm assets include assets managed by sub-advisors that the firm has authority to select but do not include advisory-only assets or uncalled committed capital.
A firm that has been defined for the purposes of the GIPS standards may undergo subsequent changes in its corporate structure or organizational design. Changes in a firm’s organization are not permitted to lead to alteration of historical performance. Indeed, it is a general rule that, apart from correcting errors, historical performance is not to be altered.
Understanding Discretion in Investment Management
Within the context of the GIPS for Firms, the term “discretion” plays a significant role. It mandates the inclusion of all discretionary, fee-paying segregated accounts in at least one composite. This rule extends to discretionary, fee-paying pooled funds if they align with a composite definition. However, the GIPS standards do not provide a clear definition of “discretionary”.
Discretionary Portfolio: Example
Consider a portfolio manager overseeing a discretionary domestic mid-cap value portfolio. This manager has the authority to purchase any stock issued within the investor’s home country that fits the relevant market capitalization and style criteria. For instance, the manager could invest in a company like Ford Motor Co., a mid-cap value stock in the U.S. market.
Defining Mid-Cap and Value Stocks
Mid-cap stocks could be defined as those with a market capitalization between $2 billion and $10 billion. Value stocks, on the other hand, might be identified by their low price-to-earnings ratio, high dividend yield, or other distinguishing features that set them apart from growth stocks.
Investment Objective
The firm and the client might agree that the portfolio’s goal is to outperform a specific benchmark that accurately gauges success in the domestic mid-cap market. This could be a custom benchmark created by the firm or a commercially available index like the S&P MidCap 400.
Discretionary vs Non-Discretionary Portfolios
While both discretionary and non-discretionary portfolios contribute to total firm assets, only discretionary portfolios are included in composites. If a client imposes restrictions that limit the manager’s ability to make investment decisions, the manager must assess whether the portfolio is truly discretionary.
Non-Discretionary Portfolio
If restrictions obstruct the investment process to the point where the strategy cannot be implemented as intended, the portfolio may be deemed non-discretionary and should not be included in a composite.
Other Fundamentals of Compliance
Our focus is on the ‘Other Fundamentals of Compliance’ under Section 1 of the GIPS. These fundamentals are important for any firm or individual aiming to claim compliance with the GIPS standards.
Minimum Years for Compliance
One of the key requirements for claiming compliance with the GIPS standards is the minimum number of years required. For instance, a firm with a five-year track record in the investment industry may be eligible to claim compliance.
Documenting Policies and Procedures
Documentation of policies and procedures related to compliance is another crucial requirement. This involves maintaining a record of all the policies and procedures, such as risk management and investment strategies, to ensure compliance with the GIPS standards.
Compliance with Laws and Regulations
Compliance with all applicable laws and regulations is also a fundamental requirement. This means that the firm or individual must operate within the legal framework, adhering to laws such as the Securities and Exchange Commission (SEC) regulations.
Avoiding False or Misleading Information
The GIPS standards require firms and individuals to avoid providing false or misleading performance and performance-related information. This is to ensure transparency and integrity in the reporting of performance data.
Distribution of GIPS Reports
The requirements concerning the distribution of GIPS Reports and lists of firm composites and pooled funds are also part of the fundamentals of compliance. These reports and lists must be distributed in a manner that is consistent with the GIPS standards.
Use of Total Return Benchmarks
The use of total return benchmarks that reflect the investment strategy is another key requirement. This ensures that the performance of the firm or individual is accurately represented and compared to the appropriate benchmark.
Correction of Material Errors
If there are any material errors in a GIPS Report, there is a requirement to correct these errors and redistribute the report to the appropriate parties. This is to ensure the accuracy and reliability of the information provided in the report.
Maintenance of Data and Information
The maintenance of data and information necessary to support the elements of the GIPS Reports is also a fundamental requirement. This involves keeping a record of all the data and information that is used in the preparation of the GIPS Reports.
Linking Performance to Another Firm
Finally, the conditions under which performance may be used or linked to that of another firm are also specified in the GIPS standards. This is to ensure that the performance data is not misrepresented or misused.
Practice Questions
Question 1: The Global Investment Performance Standards (GIPS) for Firms’ Section 1, titled “Fundamentals of Compliance,” is a critical part of the standards. It includes several requirements and recommendations that are essential for understanding the required fundamentals of compliance. Which of the following statements is correct regarding compliance and GIPS?
- The concept of discretion is technically part of the Fundamentals of Compliance.
- The definition of the firm is not a critical component of the GIPS standards.
- Both the definition of the firm and the concept of discretion are important for a complete understanding of the GIPS standards.
Answer: Choice C is correct.
Both the definition of the firm and the concept of discretion are indeed important for a complete understanding of the GIPS standards. The definition of the firm is a critical component of the GIPS standards because it establishes the entity that claims compliance with the standards and is responsible for ensuring that all the requirements are met. It is the firm that is held accountable for the accuracy and completeness of the performance presentations. On the other hand, the concept of discretion is integral to the application of the GIPS standards. It refers to the ability of the firm to implement its investment strategy and make investment decisions without restrictions. A firm must have discretion over the assets it manages to claim compliance with the GIPS standards. Therefore, both these concepts are crucial for understanding and applying the GIPS standards.
Choice A is incorrect. While the concept of discretion is indeed important for understanding the GIPS standards, it is not technically part of the Fundamentals of Compliance. The Fundamentals of Compliance section outlines the basic principles that a firm must adhere to in order to claim compliance with the GIPS standards, but it does not specifically include the concept of discretion.
Choice B is incorrect. The definition of the firm is indeed a critical component of the GIPS standards. It is the firm that claims compliance with the GIPS standards and is responsible for ensuring that all the requirements are met. Therefore, understanding the definition of the firm is crucial for understanding the GIPS standards.
Question 2: An investment firm has a division that specializes in providing investment management services to private clients. This division is marketed as a specialist in meeting the investment needs of high-net-worth individuals and family offices. It is incorporated as a subsidiary and has its own dedicated financial analysts, portfolio managers, and traders located in a separate building. They report through a separate chain of command to the parent organization’s senior management. In the context of compliance with the GIPS standards, how would this division be classified?
- As a distinct business entity, but not a firm.
- As a firm.
- As a subsidiary, but not a firm.
Answer: Choice A is correct.
This division would be classified as a distinct business entity, but not a firm, in the context of compliance with the Global Investment Performance Standards (GIPS). According to the GIPS standards, a firm is defined as an investment firm, subsidiary, or division held out to clients or potential clients as a distinct business entity. In this case, the division is marketed as a specialist in meeting the investment needs of high-net-worth individuals and family offices, and it operates independently with its own dedicated staff and separate reporting chain. However, it is still part of the parent organization and is not a separate legal entity. Therefore, it would be considered a distinct business entity, but not a firm, under the GIPS standards. The GIPS standards are designed to ensure fair representation and full disclosure of investment performance, and understanding the classification of different business entities is crucial for compliance.
Choice B is incorrect. The division is not a firm because it is not a separate legal entity. It is a part of the parent organization and operates under its umbrella. While it has its own dedicated staff and operates independently, it is still controlled by the parent organization and is not held out to clients or potential clients as a separate firm.
Choice C is incorrect. While the division is a subsidiary in the sense that it is a part of the parent organization, it is not a subsidiary in the legal sense. A subsidiary is a separate legal entity that is owned by another company. In this case, the division is not a separate legal entity, but rather a part of the parent organization. Therefore, it would not be classified as a subsidiary under the GIPS standards.
Glossary
- Firm: A business organization, such as a corporation or partnership, that sells goods or services to make a profit.
- Discretion: The authority to make decisions without needing approval from someone else.
- Distinct Business Entity: A unit, division, department, or office that is organizationally and functionally segregated from other units.
- Total Firm Assets: The aggregate fair value of all assets for which a firm has investment management responsibility.
- Global Investment Performance Standards (GIPS): Ethical standards to be used by investment managers for creating performance presentations that ensure fair representation and full disclosure of investment performance.
- Discretionary Portfolio: A portfolio where the manager has the authority to execute the investment strategy.
- Non-Discretionary Portfolio: A portfolio where the client imposes restrictions that limit the manager’s ability to execute the investment strategy.
- Composite: An aggregation of one or more portfolios managed according to a similar investment mandate, objective, or strategy.
LOS 3(b): explain the fundamentals of compliance with the GIPS standards, including the definition of the firm and the firm’s definition of discretion.