What are the key rules for GIPS composite construction and how do firms decide which portfolios go into which composite?

GIPS composite construction is the backbone of the standards because composites are how firms present their track records to prospective clients. The fundamental principle is that composites must include all actual, fee-paying, discretionary portfolios managed according to a specific strategy.

Core Composite Construction Rules:

1. All Fee-Paying Discretionary Portfolios — If a portfolio is managed with full discretion and pays fees, it must be in at least one composite. Firms cannot cherry-pick their best accounts.

1. Consistent Strategy Definition — Each composite must have a clear, documented investment mandate. For example, 'US Large Cap Growth — minimum $1M, benchmark Russell 1000 Growth.'

1. New Accounts — Must be added to the composite on a timely and consistent basis. Most firms use a policy like 'included after the first full month under management' or 'after funding is fully invested.' The key is consistency — you cannot delay adding poor performers.

1. Terminated Accounts — Must remain in the composite's historical record up through the last full measurement period they were managed. You cannot retroactively remove a fired client's poor returns.

1. Non-Discretionary Portfolios — Excluded. If a client imposes restrictions (e.g., 'no tobacco stocks' on a broad equity mandate) that prevent the firm from fully implementing the strategy, the account is non-discretionary for that composite.

Significant Cash Flows:

GIPS allows firms to define a significant cash flow policy. If a client deposits or withdraws a large amount (e.g., >10% of portfolio value), the firm may temporarily remove the portfolio from the composite until the cash is invested. This prevents cash drag from distorting composite returns.

Minimum Asset Level:

Firms may set a minimum portfolio size for composite inclusion (e.g., $500,000). Portfolios below this threshold can be excluded because small accounts may not be representative of the strategy.

Exam Focus: Expect questions asking you to determine whether a specific portfolio should be included in or excluded from a composite, based on discretion status, cash flow events, or account inception timing.

Dive deeper into GIPS composite rules in our CFA Level III study materials.