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Disclosure Considerations for ETF Managed Portfolios

An increase in awareness will help to mold industrywide best practices.

Ling-Wei Hew, 07/28/2014

Performance presentations are almost always concise and minimal. They are often featured as a means of grabbing the attention of potential investors by showcasing a strategy’s accomplishments. However, as a result of their apparent simplicity, there is a tendency among those scrutinizing performance figures to gloss over the fine print that accompanies them. This would be analogous to watching a commercial for a new wonder drug and plugging one’s ears during the part where the narrator spells out the potential side effects (what is somnolence, anyway?).  

Performance reports form the backbone of every investor’s due-diligence process. Just as satisfactory performance is essential, so is the need to develop an understanding of exactly what is behind those performance figures. The spotlight now needs to broaden to cover all necessary disclosures, so that investors can make fully informed decisions. 

The first part of this article will examine disclosure considerations pertaining to performance numbers in isolation—just what these figures mean and how they are being presented. The second part will delve deeper into the disclosures and due diligence needed to shed light on a strategy’s investment process and the composition of its performance metrics. 

Part 1: Performance Disclosure Considerations
The reliability of any assessment of a strategy’s performance hinges on the consistency and credibility of its performance reports. Standardization and transparency are required to level the playing field and foster fair and accurate evaluation. While the numbers themselves are a useful tool to evaluate the success of a strategy, it is critical that investors not judge books by their covers. 

The Global Investment Performance Standards
The Global Investment Performance Standards (GIPS) were developed as a means of creating a set of recognized standards for calculating and presenting investment performance to investors around the world. The overarching objective of GIPS is to foster fair competition and instill investor confidence. 

GIPS spell out a host of requirements that firms must meet before they can claim compliance, and the standards even go to the extent of defining a supplementary list of recommendations. While compliance with GIPS instills a level of assurance around the accuracy of a firm’s performance reporting it is by no means a guarantee against fraud or outright misrepresentation. It should also be noted that although a strategy’s track record may be a useful indicator of its behavior across different market environments, it is a backward-looking indicator and not indicative of future performance. Furthermore, it does not indicate a strategy’s fit within a client’s portfolio or how the strategy might perform alongside other investments. 

The requirements set by the standards should be seen as a minimum requisite for firms to effectively communicate the details of their strategies’ performance. And while the recommendations go above and beyond what is mandatory to claim GIPS compliance, they add the final splash of color to the industry’s best-practice guidelines and should be factored into a holistic evaluation process. 

The commitment to GIPS is made at the firm level. There is no flexibility allowing for partial compliance or creating exceptions for any composites. Compliant firms will use standardized statements, approved by the CFA institute, that clearly state firm-wide compliance and also whether the firm has been verified by an independent third party. External verification further bolsters the credibility of a firm’s compliance claim and is optional (it is not required to claim compliance). While the marketing advantage is clear, the thorough examination of a firm’s procedures undertaken through the external verification process also serves to strengthen internal processes and controls, adding an additional layer of assurance for future reporting. 

Ling-Wei Hew is an analyst on the passive funds research team for Morningstar. In this role, she is responsible for researching and providing commentary on ETF managed portfolios.

Hew holds a bachelor’s degree in economics from Wellesley College. She also holds the Chartered Financial Analyst® designation. 

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