GIPS(R) compliant firms are required to include all actual (i.e., a REAL account, not a model), fee-paying (i.e., that the account pays fees, though this may change with GIPS 2010 to mandate the inclusion of non-fee paying accounts, too), discretionary accounts into at least one composite. Let us turn our attention to the word, “discretionary.” What is meant by this?
First, the term is admittedly confusing. We are already aware of the legal definition: that is, a firm is legally discretionary if they have granted the portfolio manager the right to trade on their behalf. Great! Is that what we mean here? NO! Then what DO we mean?
We mean GIPS discretionary. In order to know if an account is discretionary from a GIPS perspective, it already has to be legally discretionary. And here we’re speaking of the cases where accounts have placed certain restrictions on the manager (e.g., no “sin” stocks). The manager gets to decide if the restriction has impeded their ability to execute their strategy.
While teaching a class recently I came across this metaphor (or analogy, if you prefer), which I think may help. Let us turn our attention to the world of cooking.
For roughly 35 years I have had the responsibility to make the stuffing whenever we have turkey. And each year I turn to my wife’s trusty Betty Crocker Cookbook for the recipe. And each time I prepare the stuffing, I do it the same way.
Now let’s suppose that I’ve been asked to prepare the stuffing for someone else and they ask me to substitute wheat bread for the white bread, or perhaps to add a cup of chicken broth to the mix. Can I do this? Yes, of course. But, can I predict what the result will be? Am I comfortable taking the praise (or criticism) for the result? Maybe not. You’ve altered my normal recipe…my normal strategy for executing my process to prepare the stuffing. And so, I may say “yes, I can do this, but you get the credit for this idea.” Thus, I might say that it’s nondiscretionary.
Returning to investing, I wouldn’t say that the client gets the credit. Clearly, I’ve agreed to do something for the client and the result is influenced by whatever that was. But, I may not feel that the result matches what would have occurred had I not had the adjustment made and thus declare it nondiscretionary for GIPS purposes.
Hope this helps! Please let me know your thoughts.