In just a few short months the 2010 edition of the Global Investment Performance Standards (GIPS) throws into sharp relief the success that industry-developed, self-policing measures can achieve in setting accepted levels of performance measurement, monitoring and attribution.

GIPS is something of a beacon for self-regulation. Ethical standards for investment performance presentation intended to ensure fair representation and full disclosure have been adopted as the local benchmark in 32 regions from the US, Switzerland and the EU, to Singapore, Russia and China. Even Pakistan and Kazakhstan have adopted the standards and are endorsed GIPS country sponsors.

GIPS has engendered a level of international cooperation rarely seen in other fields. Its success derives from its value. The stated objective of the GIPS Executive Committee is: “the establishment of a voluntary global investment performance standard that leads to an accepted set of best practices for calculating and presenting investment performance that is readily comparable among investment firms, regardless of geographic location.” They are also intended to: “facilitate a dialogue between investment firms and their existing and prospective clients regarding investment performance.”

In practice, it means that individual hedge fund investment firms from New York to New South Wales have a globally recognised badge of honour that attests to their performance measurement operations – and a valuable front-line sales tool as a result. Their clients and prospects, in the form of pension plans, endowment funds and foundations gain access to information about the performance of various investment strategies that enables them to make more informed investment decisions. Even players in the retail investment space, whose mutual and hedge funds are covered by separate regulations, are beginning to look at the GIPS standards as a means of demonstrating competitive advantage.

So there is a clear advantage to establishing the appropriate processes and systems, and going through the validation procedure to prove compliance. That advantage has never been more obvious than in today’s highly competitive markets. Risk averse institutional investors are looking very carefully at where they place their money and require greater than ever reassurance about the quality and probity of their investment managers.

At the same time, international markets are opening up and offering an attractive alternative source of alpha to the crisis-battered Western markets. But because investment practices, regulation, performance measurement, and performance reporting vary considerably from country to country, asset managers, their clients and their prospects benefit from an established global standard for calculating and presenting investment performance. The GIPS standard acts like a passport: enabling firms to enter new markets and offer services that are recognised to be of the highest standards. By adhering to these global standards, firms in countries with minimal or no investment performance standards will be able to compete for business on an equal footing with firms from countries with more developed standards. And firms from countries with established practices will have more confidence in being compared fairly with local firms.

In general, compliance with the GIPS standards helps improve investor confidence because it requires all-important performance information to be fairly represented and fully disclosed. There is nowhere to hide from shoddy or substandard performance: success comes from actual results not tired reputations.

GIPS also puts the spotlight on data integrity, in fact the GIPS standards rely on the accuracy of investment performance data. It is critical to the accuracy of the performance measurement and presentation of performance records, since it is the underlying valuations of the portfolio holdings that drive the portfolio’s performance. With this in mind, the GIPS standards require firms to adhere to certain calculation methodologies and to make specific disclosures along with the firm’s performance.

The recent changes, which must be implemented by January 2011, also state that assets must be valued using ‘fair value’ rather than ‘market value’ to help overcome the problems associated with valuing derivative instruments. It is a clear response to the events of the last few years, as is the new requirement to address risk in the GIPS standards. Because understanding past performance requires an understanding of the risks taken to achieve the performance, firms will be required to present the standard deviation of their monthly returns in both the composite and the benchmark.

The markets have also seen more of a shift from buy-and-hold to transaction based attribution, thanks largely to the rising interest in fixed income asset classes. From a performance angle it makes the data quality from the portfolio side much better, and it assists in discovering where true active return is coming from.

These moves add even more pressure on the data requirement for GIPS compliance. It is a critical area that can be overlooked in the rush to secure the right attribution system and the right reporting tools, putting these in place, and integrating them with other front-office systems. It can add considerably to the cost of GIPS compliance: consider the costs and resources required to build and secure an appropriately comprehensive data warehouse, monitor benchmark data and confirm its accuracy and validity, build feeds to various systems, update data in line with market changes and client requirements, and then manipulate data to turn it into useful information for performance measurement and attribution.

This is the dilemma that hedge fund firms must weigh up. There is no denying the value of GIPS validation, particularly when risk-averse investors have to navigate markets that have yet to return to stability. At the same time those volatile markets make the provision of accurate, verified benchmark data more costly than ever, but without which there is no hope of GIPS compliance.

Perhaps it is no surprise that more and more hedge fund firms are turning to outsourced data management provision, and the economies of scale offered by third party specialist providers, in their quest for GIPS compliance.

GIPS is a great example of what can be achieved through self-regulation. The new standards present an ideal opportunity for hedge fund managers to revisit GIPS, examine the benefits and look into the obligations. There is much to be gained – and thanks to the availability of benchmark data management providers – little to be lost.

Any firm that is unnecessarily squeamish about outsourcing data management, and reject GIPS as a result, may discover that GIPS compliance is in fact a far better option than handing performance management over to the tender mercies of external regulators.

David Spaulding is founder of the Spaulding
Group which together with RIMES Technologies co-hosted in June the first annual European Performance Measurement, Attribution and Risk conference in London. He consults to clients throughout the world on investment performance issues. In addition, he is the author of three books: Measuring Investment Performance, Investment Performance Attribution and The Handbook of Investment Performance.