GIPS is a critical term for hedge fund investors to be familiar with. It stands for Global Investment Performance Standards, which are a set of best-practice guidelines for reporting performance issued by the CFA Institute.
Q. This is one of those really important terms for people looking at investing in Hedge Funds, right?
A. It is, especially these days. It stands for Global Investment Performance Standard, put out by the CFA Institute. It’s a very well developed and broadly followed measuring stick for hedge fund managers. A key question to know is whether a track record that you’re being shown is “GIPS compliant”. Nearly all industry consultants require that in funds they evaluate, and about 75% of hedge fund managers say they are GIPS compliant.
Q. So when and where does the GIPS methodology matter most?
A. One of the really critical issues for newer managers is that they often put “pro forma” numbers in front of investors. “Here’s my strategy, and you can see that if I’d run this over the past several years, it would have made a fortune.” Sometimes, that legitimate: for example, if the guy really was running that exact strategy for SMAs, and now he’s moving it into a fund, which is very common. He should be able, however, to say that the calculation is GIPS compliant.
Q. So there are many different ways that performance can be measured… what does GIPS say about this?
A. GIPS requires a time-weighted methodology, not a dollar weighted methodology. That’s an instructive point. In general, time weighted methodologies are the industry standard for hedge funds because they are dealing in liquid securities with real market pricing… its easy to get the numbers quarterly and make some sense of them. Dollar weighted performance, like IRR, is preferred for private equity investors, because, among other things, pretty much the only way you can really calculate performance is by discounting the cash flows.
Q. And this is calculated by the fund itself? Is there someone around to verify the results?
A. There are many third party firms that specialize in confirming a manager’s GIPS track record, and the results should be confirmed by one of them before the manager advertises the GIPS number. So one thing investors can do is just check out who’s done the checking out… that should give you a good sense of confidence that the historic performance numbers you’re looking at are real.