Saturday, April 20, 2013

A little piece on GIPS...


Earlier this week, I wrote a guest blog post for STP Investment Services on the What, Why and Who of the GIPS Standards.  Good summary info for CIPM Principles candidates!

Read the blog post here!

Wednesday, April 10, 2013

GIPS: Supplemental Information vs. Additional Information




In the world of GIPS compliance and composite presentations, there is "supplemental information" and there is also "additional information"... but what is the difference?

When I explain these concepts to students in The Spaulding Group's classes or to our verification clients, I tell them it is helpful to think of the following concepts:

  • required information:  any information that is required by the provisions of GIPS, or by any guidance statements, Q&As, the GIPS Handbook, gipsstandards.org, updates or clarifications from the GIPS Executive Committee, etc.
     
  • recommended information:   any information that is recommended by the provisions of GIPS, or by any guidance statements, Q&As, the GIPS Handbook, gipsstandards.org, updates or clarifications from the GIPS Executive Committee, etc.
  • additional information:  information that is required or recommended by the GIPS Standards
     
  • supplemental information:  Any performance-related information included as part of a compliant presentation that supplements or enhances the required and/or recommended provisions of the GIPS standards 
For example, let's say a firm is showing both gross-of-fees and net-of-fees returns in a compliant composite presentation.  Can the firm label either the gross returns or the net returns as supplemental information?

The answer is no, gross return and net returns must not be labeled as supplemental information, because they are additional information.  GIPS provision I.5.A.1.b requires firms to show either gross returns or net returns (whichever is shown  must be clearly labeled as such).  But because gross returns and net returns are covered by the requirements of GIPS (i.e., they are required information), they fall under the category of "additional information" and cannot be labeled as supplemental information.  To do so could be interpreted by a reader of the composite presentation as de-emphasizing what is really a required presentation element.  True, GIPS provision I.5.A.1.b allows the firm to show gross returns or net returns, but a firm showing both cannot de-emphasize one of the returns by labeling it as supplemental.

Note:  supplemental information must be clearly labeled in a composite presentation.  Normally, required information, recommended information and additional information would not be labeled as such.

Tuesday, April 9, 2013

Campisi's Index Portfolio Explained






A common question I get is what is the purpose of the "index portfolio" used in the Campisi fixed income attribution model.

Before answering, let me first give an outline of the steps in calculating attribution in the Campisi framework.

Step 1:  Decompose the benchmark return
1.1 Calculate the contribution of income to the benchmark return
1.2 Calculate the contribution of Treasury to the benchmark return
1.3 Calculate the contribution of spread to the benchmark return

Step 2:  Decompose the index portfolio return

2.1 Calculate the contribution of income to the index portfolio return
2.2 Calculate the contribution of Treasury to the index portfolio return
2.3 Calculate the contribution of spread to the index portfolio return

Step 3:  Decompose the portfolio return
2.1 Calculate the contribution of income to the portfolio return
2.2 Calculate the contribution of Treasury to the portfolio return
2.3 Calculate the contribution of spread to the portfolio return
2.4 Calculate the contribution of selection to the portfolio return

Convenient fact #1:  Knowing the benchmark return and having calculated the contribution of income and the contribution of Treasury to the benchmark return, we can back into the spread contribution - it's everything that's left.

Convenient fact #2:  Knowing the index portfolio return and having calculated the contribution of income and the contribution of Treasury to the index portfolio return, we can back into the spread contribution - it's everything that's left.

Inconvenient situation:  We can't back into the spread contribution of the portfolio, knowing the income and Treasury contributions, because spread contribution is not all that is left... there is also the selection contribution.  Thus, we need a specific formula for the spread contribution to the portfolio return.


Spread contribution is an element of price return.  And price return is always dictated by the change in interest rates during the period.  Specifically, if we know the duration of the given portfolio (or benchmark, etc) at the start of the period, and if we know how much interest rates have changed during the period for bonds of that duration, then we can calculate the price return caused by changes in interest rates as:

return contribution = (-1) * (duration) * (change in interest rates)

Note:  the (-1) is because of the inverse relationship between interest rate change and bond prices.

We use this formula in various situations in the Campisi model.  When calculating Treasury contribution, for example, the relevant change in interest rates to use in the formula is the change in Treasury interest rates for the given duration.  But when calculating spread contribution, we are trying to calculate the return contribution from the non-Treasury securities (in excess of the Treasuries).  Thus, the relevant interest rate to consider is the interest spread paid by non-Treasuries in excess of Treasuries of the same duration.  And the change in interest rates, then, is the amount that the spread changed over the evaluation period.  A positive number indicates that the spread paid by non-Treasuries over Treasuries (of the given duration) increased during the period (i.e., the spread widened).  A negative number indicates that the spread paid by non-Treasuries over Treasuries decreased (i.e., the spread narrowed).

So then, back to the original question, what is Campisi's index portfolio?

The relevant change in interest rates to calculate spread contribution for the portfolio is based on the index portfolio.  The index portfolio is a hypothetical portfolio based on the manager's (portfolio) sub-sector weights but benchmark sub-sector returns.  I often describe it to students in our classes as being analogous to Brinson's semi-notional portfolio used in stock attribution, reflecting the manager's weighting decision but retaining the security selection of the benchmark.  The index portfolio, by using the sub-sector weights of the portfolio and the benchmark sub-sector returns:
  • reflects the income contribution of the portfolio
  • reflects the Treasury contribution of the portfolio (i.e., the manager's duration decision)
  • reflects the manager's allocation to sub-sectors
  • retains the security selection of the benchmark
Thus, by using the formula:

spread contribution = (-1) * (duration) * (change in index portfolio spread)

we can calculate a spread contribution for the portfolio that is free from the manager's security selection.

In reality, we could also use the last formula above to calculate spread contribution for the benchmark and for the index portfolio (steps 1.3 and 2.3), if we knew the appropriate change in spread rates to use.  But, we make use of the "convenient facts" stated above to do so more efficiently.

Happy studying!

Monday, April 8, 2013

Calculating IRR - Another CIPM Principles exercise

A CIPM Principles candidate sent an email asking how to calculate the internal rate of return in the exercise shown in Exercise 36 in the CIPM Principles Curriculum (on page 234).  In this example, the following information is given:

  • Account market value on 1/1/10 is $237,000
  • Dividends of $8,000 are paid on 7/1/10.  These dividends are not reinvested (which means they are withdrawn from the account rather than remaining in the account).
  • Contribution of $40,000  is made on 10/1/10
  • Account market value is $329,000 on 12/31/10.  There was also a dividend of $8,000 paid on this day that was not reinvested.
 The above is the relevant information to the internal rate of return calculation; anything else that is given can be ignored for purposes of exercise 36.

In order to do this calculation, you need to determine the intervals at which cash flows will be entered into the calculator.  I am going to use quarterly cash flows.  Here is the information to be entered into the calculator:

CF(0) = -237,000      (this is the starting value of $237,000)
CF(1) = 0                  (no cash flow occurs on 4/1)
F(1) = 1                     (the cash flow of zero occurs once)
CF(2)= 8,000            (the withdrawn income of $8,000 on 7/1)
F(2)=1                       (this cash flow occurs once)
CF(3)= -40,000         (the contribution of $40,000 on 10/1/10)
F(3)=1                       (this cash flow occurs once)
CF(4)= 337,000       (combination of ending market value of $329,000 and the withdrawn income of $8,000)
F(4)=1              (this cash flow occurs just once)
Compute IRR

This should give you an IRR of 6.378%.  This is a quarterly number, and the exercise wants an annual return.  Thus, you should do the following steps to convert the quarterly return to a annual return:
  • add 1 to 6.378%
  • raise 1.06378 to the 4th power (as there are four quarters in a year)
  • subtract 1
  • multiply by 100 to create the percentage
 Thus the answer is 28.1%.

Having said all of that - stay tuned - on Wednesday I will show what many candidates may find to be a faster way of solving this particular problem.

Calculating IRR - CIPM Principles Exercise

A CIPM Principles candidate sent an email asking how to calculate the internal rate of return in the exercise shown in Example 26 in the CIPM Principles Curriculum (on page 198).  In this example, the following information is given:

  • Account market value on 3/31 is $56.3 million
  • Account market value on 4/11 is $58.2 million (prior to contribution on same day)
  • Contribution of $9.8 million is made on 4/11
  • Account market value of $69.6 million on 4/30
 You can ignore the market value on 4/11; this information is not needed to calculate IRR.

In order to do this calculation, you need to determine the intervals at which cash flows will be entered into the calculator.  I am going to use daily cash flows.  Here is the information to be entered into the calculator:

CF(0) = -56.3      (this is the starting value of $56.3 million)
CF(1) = 0            (no cash flows occur from 4/1 through 4/10)
F(1) = 10            (ten days of zeros)
CF(2)=-9.8         (the contribution of $9.8 million on 4/11)
F(2)=1                (this contribution occurs just once)
CF(3)=0             (no cash flows occur from 4/12 through 4/29)
F(3)=18             (18 days of zeros)
CF(4)=69.6       ($69.6 million is the ending value)
F(4)=1              (this cash flow occurs just once)
Compute IRR

This should give you an IRR of 0.1819%.  This is a daily number, and the exercise wants a monthly return.  Thus, you should do the following steps to convert the daily return to a monthly return:
  • add 1 to 0.1819%
  • raise 1.001819 to the 30th power (as there are 30 days in April)
  • subtract 1
  • multiply by 100 to create the percentage
 Thus the answer is 5.60%.