The headline claim "GIPS-compliant" may reveal very little about how an RIA actually has managed money for individual investors over time, or will perform in the future.  In some cases, the track record shown beside this claim is for a longer period than the RIA has been managing money professionally.

GIPS is a complex system to understand or implement – and that's especially true for RIAs managing separate accounts.

What GIPS does best

At its best, GIPS helps pension plans, endowments and consultants evaluate and compare track records of portfolio managers all over the world under consistent assumptions, calculations and formats. Also, GIPS holds portfolio managers to ethical standards for fair representation and full disclosure.

The key building block of GIPS is a "composite," an aggregation of portfolios into a group with a common objective or strategy. GIPS requires all of a firm's discretionary, fee-paying portfolios to be included in at least one composite.

However, firms generally have fairly broad discretion about how they build composites. For each portfolio included in a composite, the manager must calculate time-weighted rates of return adjusted for daily cash flows. However, composite performance is calculated by rolling up the performance of all component portfolios on an asset-weighted basis. To document this data, firms need powerful trade management software and systems, and these systems should have been in place for as long as the GIPS-compliant track record.

According to industry surveys, a majority of GIPS-compliant managers now hire a third-party verification firm to test methodology and compliance.  This creates extra cost for portfolio managers, while giving investors an independent source to document GIPS claims. However, keep in mind that verification firms don't generate GIPS data – they just check it.

Given these complexities, GIPS works best for large discretionary managers who:

• Can afford the high cost of GIPS compliance, tracking software and verification services.
• Manage institutional portfolios or pooled funds in which many investors share a common track record, e.g., hedge funds.  
• Manage assets consistently under strategies or styles that create clearly defined composites.

If an RIA is trying to help individual investors meet personal objectives in separate accounts, with some customization, GIPS performance may not reveal very much. In smaller firms, it also can be a costly distraction that keeps RIAs from giving each client the personal service they need and expect.

A closer look at GIPS

Why are managers who cater mainly to individual investors flocking to GIPS? The answer may come down to wanting to compete with the big boys and attracting new business, not serving individual clients better.

GIPS gives managers an apparently credible way to answer a prospect's frequently asked question: "What has been your track record?" It also helps managers pass through performance screens set up by consultants.

But is advertised GIPS performance always reliable? For RIAs, the answer depends on a thorough evaluation of many complex details in GIPS reports, including arcane disclosures and footnotes. For example:

• Footnotes may show that historic composite performance is based on a very small number of accounts and asset, far fewer than the RIA is currently managing.
• Actual internal rates of return that a manager delivered to clients, net of all costs, may be different than the asset-weighted roll-up of account performance into a composite. This is more likely to be true if the firm's business has been concentrated in a few accounts.
• Composite performance can be based on a different style or strategy than the RIA is managing currently. Although this should be disclosed, the language can be difficult to decipher.
• In some cases, composite performance is based on trades made by an individual or employee, before the firm itself was registered to manage assets professionally.

GIPS allows back-tested or theoretical performance results to be used, if disclosures attest that all securities used in the model were available during the period presented. For example, footnotes may disclose that "actual results may significantly differ from theoretical returns presented."

The alternatives to GIPS

Given these caveats, what are the alternatives to relying on GIPS performance in evaluating RIAs? They all require more digging than buying a "GIPS-compliant" headline:

• SEC advertising guidelines – In many cases, the SEC's advertising requirements for investment advisers are more direct than the GIPS guidelines. For example, the SEC says that if advisers use a model's performance results, they must disclose situations in which some securities or strategies included in the model do not relate to services currently offered. Advisers also must disclose when clients had actual investment results materially different from those shown in the model. A comprehensive guide to the SEC's advertising requirements for RIAs is here: https://www.morganlewis.com/pubs/SEC-RegulationAdvertising-InvestmentAdvisers_Nov2012.pdf Bottom line: If you must wade through footnotes to decipher an RIA's track record, focus on the SEC's, not the GIPS.
• Form ADV – The most important disclosure document for RIAs is the Form ADV filed with the SEC and searchable here: http://www.adviserinfo.sec.gov/IAPD/Content/Search/iapd_Search.aspx

Item 2, Line C reveals the states in which the RIA is registered; most RIAs who manage separate accounts for large numbers of clients are registered in many states. Item 5, Line A, reveals the number of people the firm employs. Schedule A lists the firm's owners and executive officers and their tenure. If a firm's GIPS performance record is longer than tenures of key people, it's advisable to ask who created it. The firm's SEC-mandated client brochure, ADV Part II, should disclose how long the advisory firm has been in business as an RIA.

• Investment Policy Statement – RIAs should be willing to share a representative IPS document, which defines each client's investment goals, risk tolerance and objectives, as well as investment guidelines for the account. An IPS is the best way to hold an adviser accountable for specific investment allocations and decisions.
• Client experience – RIAs are not allowed to market client testimonials or show "cherry-picked" client account performance as evidence of a track record. However, it is a good idea to seek out current or former clients of an adviser (or their investment professionals) and ask them to relate personal experiences. Often, it's not the detailed performance numbers that matter most to clients. It's the consistency of performance and the confidence an RIA inspires in communicating investment strategies and adjustments.

Over 15 years, GIPS has grown into a viable standard for performance reporting for institutional managers and hedge funds. But for many RIAs who offer separate accounts, complying with GIPS is like building a miniature boat in a bottle. The work is tedious and intricate – to do and to understand – and ultimately it doesn't really help to carry a client across choppy investment waters.

If an RIA serves individual investors in separate accounts, each client deserves performance reporting on an internal rate of return basis that takes into account all cash flows and costs. A GIPS track record based on a composite may not reflect the real-world experience of any specific client, let alone a representative client over the full track record advertised.

GIPS compliance and verification can be burdensome and costly for all discretionary managers, especially those who are small to mid-sized. For many RIAs who manage separate accounts, the money and time allocated to GIPS compliance could be better spent on consolidated wealth reporting software and systems, designed to help each client customize personalize portfolios and track results.

GIPS compliance isn't a value-add for clients. If anything, it beefs up the RIA's marketing and asset-gathering program, pushing AUM beyond the adviser's capacity to serve individuals well, in some cases.

For most RIAs, the keys to success in today's competitive separate account market are portfolio customization and personal communication. What advisers have done for a nebulous "composite" in the past is not nearly as important as what they will do for each individual client in the future.