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News November 15, 2004 Issue

CFA Institute Issues New Guidance Statement on Wrap Fee Accounts

Itís baaaack . . . .

After being told that its June 2002 wrap fee guidance statement did not make "practical business sense" and would impose "unreasonable burdens" on advisers, the CFA Institute (formerly AIMR) has come up with a new proposed "Guidance Statement on Wrap Fee/Separately Managed Account Performance." Comments are due by December 31. The proposed effective date is January 1, 2006. The statement would apply to firms that claim either AIMR-PPS or GIPS compliance (the June 2002 statement would have applied only to firms claiming AIMR-PPS compliance).

The new statement bears close resemblance to the June 2002 statement. For example, the statement contemplates that to satisfy recordkeeping requirements, wrap managers may have do shadow accounting or obtain an agreement from the wrap sponsor that the manager will have access to the underlying records.

Gnashing your teeth already? Keep reading . . . .

"Understanding that firms may not be able to gain access to the records necessary to substantiate performance on a retroactive basis," the new statement grandfathers pre-January 1, 2006 performance, even if manager has not maintained the required records for that period. The provision allows firms to link pre-January 1, 2006 performance "without the necessary records to support the figures" to the firmís ongoing performance record.

But thereís a catch, and it looks to be a big one: The firm must disclose the periods of non-compliance and explain how the presentation is not in compliance with the standards (namely, that the firm does not have the records to substantiate performance).

Since advisers are required to maintain performance backup under Advisers Act Rule 204-2(a)(16), many advisers wonít want to make the disclosure and therefore wonít rely on the grandfathering provision, predicted Kirkpatrick & Lockhart LLP partner Michael Caccese. "Nobodyís going to say ĎWe donít have the recordsí because that also means they violated the Advisers Act," he said.

But another industry lawyer didnít think that the disclosure requirement would present much of an obstacle. "The most important thing people are going to care about is maintaining AIMR compliance," said the lawyer. "They will word this disclosure as eloquently as possible" so that it is not an admission that "We donít have the records." Many advisers, he said, will say something along the lines of "Historically, we had relied on the sponsors to maintain the underlying records."

Of course, the grandfathering provision only excuses pre-January 1, 2006 performance from the recordkeeping requirements. Starting in 2006, managers are "back in the same boat," as Caccese put it. Going forward, advisers either will have to set up a shadow accounting system or find some way to work with their program sponsors to determine what information, exactly, the sponsor will provide and whether that information will suffice for AIMR-PPS or GIPS purposes.

That may be easier said than done. "I have yet to find one sponsor that is going to represent that they are keeping the records and calculating performance in accordance with AIMR," said Caccese. He noted that not only must the sponsor agree to calculate in accordance with AIMR-PPS or GIPS, but in accordance with things such as the managerís own cash flow policy. No sponsor, he said, will be willing to make that representation.

However, the new statement, as well as another recently-released CFA Institute guidance statement on recordkeeping, contemplates that there are multiple ways that an adviser can satisfy the recordkeeping requirements. For example, the wrap statement specifically states that use of aggregate level information obtained from the wrap sponsor is acceptable as long as the policy is fully disclosed.

A Q&A contained in the statement noted that if a manager is not able to obtain adequate supporting records from, say, one out of 45 sponsors, that would not necessarily prevent the manager from claiming compliance. "[O]ne troublesome SMA sponsor would not, in all cases, prevent the firm from claiming GIPS compliance," said the statement, adding that the firm should consider the records that are available for that wrap program and assess whether it can place reliance on those records. "In many instances, some records are available for all portfolios ó regardless of SMA sponsor ó such as trading records and summary information." Although that level of detail "may not be ideal," the firm may be able to determine that the minimal records available are enough to satisfy the GIPS requirements, said the statement.

Alecia Licata, vice president of investment performance standards at the CFA Institute explained: even if a wrap sponsor is not willing to provide full access to the account-level data, "the manager is getting some data" in order to manage the account. Managers, she said, should look at the data they receive and see if they can extrapolate the necessary information to back up their performance. "Look at what you have," she advised.

However, the statement warns that firms must "exhaust all methods to gain, recreate, or obtain access to the performance records to substantiate portfolio returns" and that "cost must not be considered an excuse for the ability of a firm to obtain records."

According to Caccese, the only thing that can solve the wrap industryís recordkeeping issue is for the industry as a whole to build a communications system between managers and sponsors, a project that the Money Management Institute has been working on for years. That project, noted Caccese, is unlikely to be finalized by January 1, 2006.

If getting wrap records under control by January 1, 2006 sounds like too much of a headache, consider this: the new statement explicitly states that recordkeeping issues might be reason enough for advisers to redefine their "firm" to mean all non-wrap accounts (assuming, of course, that the other criteria for defining the "firm" are met, i.e., the non-wrap portion of the firm is held out to clients as a distinct business unit). Thatís a notable change from the June 2002 statement, which warned that recordkeeping issues would not be an acceptable reason for an adviser to define the firm to include only non-wrap accounts.

Of course, the "redefine-the-firm" solution may not work for all advisers. For advisers with long-standing wrap and non-wrap business, redefining the firm will, at a minimum, involve recalculating assets under management and other firm-wide statistics. And, if wrap and non-wrap accounts have been lumped in the same composite, the firm will have to "re-composite" the composite to reflect only non-wrap accounts. The amount of effort it will take to redefine the firm will depend on how the accounts have been tracked along, Licata explained.

But Caccese predicted that for many advisers, a one-time re-crunching of the numbers will be more attractive option than having to set up a shadow accounting system or dealing with ongoing recordkeeping issues with various wrap sponsors. "People are just going to divide up their firms into an institutional management arm and the SMA arm," he said. He noted that because of GIPS and AIMR-PPS requirements around defining the "firm" (namely, it has to be held out as a distinct business unit), "basically you have to go through the whole rebranding process," said Caccese. "Itís a high hurdle," he added, "but itís a lot cheaper than shadow accounting."

The new statement now contemplates that a non-AIMR compliant firm can show AIMR compliant performance. It also addresses the presentation of wrap performance to potential clients (end-user investors as well as program sponsors) as well as current clients.

The CFA Institute is hoping that the new statement closes the gap between the aspirational goals of AIMR-PPS and GIPS and the practical realities of the wrap industry. After the industryís reaction to the June 2002 statement, said Licata, "we went back to the fundamentals and asked ourselves, ĎLook, what are we trying to accomplish?" While she said that the group wanted to remain true to the standardís bedrock principles of fair representation and full disclosure, they realized that advisers "need to have some choices." As a result, the new statement provides "a great deal of flexibility."