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News September 4, 2006 Issue

Compliance Issues Raised by MSP and UMA Accounts (Part 2 of 2)

Before turning to the application of the GIPS standards to multi-style portfolio (MSP) or Unified Management Account (UMA) accounts, letís peel the onion a bit more on last weekís assets under management discussion.

According to Kirkpatrick & Lockhart partner Michael Caccese, there are three general types of MSP/UMAs. The first category of accounts are those where the underlying manager enters a trade, which sits unexecuted at the sponsor until the overlay manager manually approves it. The second category involves accounts where the underlying manager enters a trade on the sponsorís platform, on which the overlay manager already has entered its front-end screens. The underlying managerís order quickly passes through the screens and, assuming it is not knocked out, is entered virtually instantaneously. The third category, which Caccese said is the newest, involves accounts where the overlay management happens after the fact, i.e., after the trade has already "hit" the account (those are the accounts that involve a Big Looming Compliance Issue, as discussed in last weekís issue ó youíll want to make sure that clients are clear about that "after-the-fact" aspect of their overlay management).

So, in each of these contexts, when would a manager have assets under management?

Again, based on the staffís reasoning in the Credit Agricole letter, some might argue that assets in the first category, where trades are held up subject to an overlay managerís approval, should not be viewed as assets under management.

Caccese, however, suggested otherwise. He pointed to the Form ADV assets under management instruction, which states that non-discretionary assets can be deemed to be receiving "continuous and regular supervisory or management services" if the manager has "ongoing responsibility to select or make recommendations, based upon the needs of the client, as to specific securities or other investments the account may purchase or sell" and if accepted, is responsible for "arranging or effecting the purchase or sale."

Caccese asserted that the "arranging or effecting" prong is met by the underlying manager initially deciding to participate in the program. In other words, by signing up to participate in a program where all transactions are effected on the sponsorís platform, the manager has made a front-end decision about how to "arrange or effect" all of the transactions conducted in the MSP/UMA accounts.

Moving to the second and third categories: Caccese suggested that when the underlying managerís orders are executed immediately after hitting an automated overlay screen, the manager should be treated as having assets under management. He also agreed that when overlay happens after the fact, the portfolios are managed in virtually the same manner as traditional discretionary portfolios and the underlying manager would clearly have assets under management.

Two other items of note: The fact that the overlay manager may have authority to wade in and make trades in the account alongside the underlying manager (for example, to free up cash, as requested by the client, or to invest new cash that comes in pursuant to the existing model) should not change the analysis of whether the underlying manager provides "continuous and regular supervisory or management services" to the account.

Second, both an underlying manager and an overlay manager can claim the same portfolio as "assets under manager" if both firms provide "continuous and regular supervisory or management services" to that account. The SEC staff has long taken the position that the same dollar can be counted as assets under management by more than one investment adviser.

Turning to GIPS . . . Thereís no official guidance statement on the applicability of the GIPS standards to MSPs and UMAs. To understand how these types of accounts fit into GIPS, one must walk through the traditional GIPS analysis.

How has the adviser defined the "firm?" Is the whole firm the "firm," or has it broken itself into a GIPS-compliant institutional division and a non-GIPS compliant wrap/SMA division? If the latter, the MSP/UMA assets would likely be assets of the non-GIPS compliant division.

Assuming, however, that the whole firm is the "firm" for GIPS purposes, the next question is . . .

Should the MSP/UMA assets be included in "Total Firm Assets?" At a minimum, if you count MSP/UMA assets for purposes of Form ADV assets under management, it seems reasonable to count them for purposes of GIPS Total Firm Assets. Under the GIPS Standards, Total Firm Assets is defined as "all assets for which a firm has investment management responsibility." As applicable to overlay managers, the definition includes "assets managed outside the firm (e.g., by subadvisers) for which the firm has asset allocation authority."

The firm must then decide whether the portfolios need to be included in a composite. Under GIPS, all "actual fee-paying, discretionary portfolios" must be included in a composite. So, assuming the MSP/UMA accounts are "actual" and "fee-paying," the question becomes . . .

Does the manager have discretion, for GIPS purposes, over the MSP/UMA accounts? If the manager does not have discretion ó and thatís discretion for GIPS purposes, mind you ó then those non-discretionary assets may not be included in the firmís composites.

Hereís the kicker: You can have general discretionary authority over an account for SEC purposes but still not have discretion for GIPS purposes. "Discretion," according to the CFA Instituteís Guidance Statement on Composite Definition, "is the ability of the firm to implement its intended strategy."

So, for example, an adviser can deem an otherwise discretionary account as non-discretionary for GIPS purposes if client-imposed restrictions such as "no tobacco" significantly hinder the firm from fully implementing its strategy.

In the MSP/UMA context, whether an underlying manager can count a MSP/UMA account as discretionary for GIPS purposes depends on what, exactly, the underlying manager is doing and how involved the overlay manager is. For example, if the underlying manager submits model recommendations to the overlay manager for the overlay manager to screen against client restrictions, possible overweightings, and wash sales, the underlying manager arguably would not have discretion for purposes of GIPS. In fact, the CFA Instituteís Guidance Statement on Wrap Fee/SMA Performance states that it is "not applicable" to managers "that provide model portfolios to wrap fee/SMA sponsors, but have no discretionary portfolio management responsibility for individual wrap fee/SMA portfolios."

Even if the overlay management occurs simultaneously or after the fact, if it significantly hinders the implementation of the underlying managerís strategy, it would seem that the underlying manager would not be deemed to have discretion for GIPS purposes. According to Caccese, "basically nine out of ten times" the underlying manager "considers these things as non-discretionary and excludes them from their composites." The portfolio managers, he noted, "are really sensitive to this stuff and they donít like an overlay manager changing their performance."

Of course, no one is crimping the style of the overlay manager. Typically, said Caccese, "the overlay manager includes everything he is responsible for as discretionary." However, if the overlay manager operates on a non-discretionary basis (i.e., must go back and ask the underlying managers to tweak their portfolios when an overweighting is spotted, rather than wading in and fixing the overweighting itself), then the overlay manager may be acting in a non-discretionary capacity. On that note, the Wrap Fee/SMA Guidance Statement explicitly states that an overlay manager in a MSP program "may also be excluded from this Guidance Statement if they do not have discretionary management."

Letís assume the account is discretionary for GIPS purposes. Now what? Once a portfolio has been identified as being an "actual fee-paying, discretionary" portfolio, it must be included in a composite. The Wrap Fee/SMA Guidance Statement contains detailed guidance for determining whether to create separate non-wrap and wrap composites, as well as whether and when a firm can create a sponsor-specific composite.

Fitting MSPs/UMAs into a composite is the easy part. The hard part is recordkeeping. Under GIPS, "all data and information necessary to support a firmís performance presentation and to perform the required calculations must be captured and maintained." The CFA Institute has consistently stated that recordkeeping challenges are not an excuse for excluding portfolios from a composite.

Like traditional wrap accounts, MSPs/UMAs present plenty of recordkeeping challenges for underlying managers. In a nutshell, there are three ways that an underlying manager in a MSP/UMA account can satisfy the GIPS recordkeeping requirements.

First, the manager can ask the program sponsor to provide it with direct access to its records, something that traditionally has not worked very well.

Second, the underlying manager can utilize shadow accounting, something that also has not worked very well.

Third, once in a program, the underlying manager can treat the sponsor as a client and create a sponsor-specific composite based on the performance provided by the sponsor. In other words, the underlying manager can "outsource" the calculation of its performance to the sponsor. However, cautions the CFA Institute, the underlying manager still is responsible for its claim of GIPS compliance and for reporting compliant information to prospective clients. "The firm must be sure that the performance provided by the wrap fee/SMA sponsor can be used by the firm to satisfy the requirements of the GIPS standards," says the Wrap Fee/SMA Guidance Statement.

How, exactly, can an underlying manager go about confirming the accuracy of sponsor-provided performance? Most obviously, the firm can conduct due diligence on the sponsorís process and methodology for preparing performance. In addition, here are some tips provided by Karyn Vincent of Vincent Performance Services:

Compare performance reported by multiple sponsors. If you are receiving performance reported by different sponsors, see if they are all "in line," Vincent suggested. "If you are managing a small cap program for five sponsors," she said, "theoretically, they are all using the same model and the performance should all be the same." That, she said, should give you a certain level of comfort. "If you have five sponsors, and you are managing them all the same and you are getting performance back from all five and they are all within a basis point [of each other,]" thatís a good sign that the performance is reliable.

Recreate the calculation on an aggregate basis. Managers should conduct spot checks to ensure that they are able to replicate the sponsorís return calculation, "so that you understand how itís working," said Vincent. For example, if the sponsor provides summary information for 200 accounts, and the monthly performance is 2 percent, the manager should, on a periodic basis be able to replicate that return "from the ground up." The key, she said, is understanding how the performance was calculated. "Iím not saying you have to go in and recreate [the performance] based on actual trades," Vincent explained. "What I commonly see people do" if they donít want to replicate each account is "treat the sponsor as one account" and "do an omnibus accounting." They take the total combined market value at the beginning and ending of the period. "Since they know the cash flows that have happened because theyíve traded those accounts, they should be able to back into the input to obtain a time-weighted rate of return," she said.

Compare sponsor-reported performance against your model. Vincent noted that managers that trade wrap accounts typically have a model. She suggested that firms compare the performance reported by the sponsors to that of their model. If it is equal, she said, that provides "another level of comfort."