CIPM Exam Tips & Tricks

Hoping for the best...

2011-10-30T16:39:00.000-07:00

Most of you have already taken the exam, so now I am hoping for the best outcome for all of you.

I came across this picture today, which expresses what I try to do when teaching. Hopefully I explained things in as simple a fashion as possible to those of you who attended our CIPM prep courses. I would also suggest this as a goal for you while you are studying: you should try to achieve a level of understanding with the curriculum topics such that you can explain the concepts in simple terms to someone else. If you can do this, I am sure you will pass with flying colors!

Macro Attribution: Behind the Return Formulae...

2011-10-21T23:06:00.000-07:00

One of the challenges for Principles Level students is dealing with the Macro Attribution model. This model for attribution measures several decisions that a fund sponsor can take to grow its fund. Because of the number of formulae involved, it seems overwhelming to some candidates. But, if you look for common themes, the Macro Attribution model is not all that complex, and the return formulae are then easier to memorize.

There are three decisions in the Macro Attribution model that are measured as relative contributions to return; that is to say, a contribution to return in excess to the prior investment decision taken by the fund sponsor. Those decisions are:

asset categories
benchmarks
investment managers

Recall that the formula for contribution is:

contribution = weight * return

The return formulae for the three fund sponsor decisions are as follows:

The asset categories return measures how much return is paid by the fund sponsor's decision to invest passively in asset classes (using index funds in the asset classes) in excess of the return paid by the risk-free rate. Thus, the asset class weight is multiplied by the excess return (broad index fund, or really, the broad index return minus the risk-free rate).

The benchmarks return measures how much return is paid by the fund sponsor's decision to invest passively in investment styles within asset classes using its own policy weights (rather than the implied weights of the broad asset class indexes) in excess of the return paid by the asset class indexes. thus, the investment style weight is multiplied by the excess return (style index fund, or really, style index return minus the broad asset class index return).

The investment managers return measures how much return is paid by the fund sponsor's decision to invest using active managers in each investment style in excess of the return paid by investing passively in those investment styles. Thus, the investment style weight is multiplied by the excess return (manager active return minus the investment style index return).

Hope this helps understand the formulae!

Short Position Weights in Menchero Market-Neutral Attribution Framework

2011-10-16T19:39:00.000-07:00

An Expert Level candidate sent me a question asking about the formula (shown above) for the asset allocation decision for market-neutral hedge funds, as discussed in the reading, "Performance Attribution with Short Positions" by Jose Menchero, Ph.D.

In particular, the candidate asked why there is an extra "minus" sign on the benchmark sector weight.

The key things to know to answer this question are as follows:

In the Menchero framework, the weights of assets (or sectors, and sub-sectors) is positive for long positions and negative for short positions.
Also, in the Menchero framework, the returns of assets (or sectors, and sub-sectors) is positive when the value of the assets goes up and negative when the value of the assets goes down.
An appropriate benchmark for a market-neutral hedge fund would be perfectly hedged. This means the benchmark is simultaneously long and short the same assets, with a 100% net exposure to cash. The reading perhaps does not explain this in detail, but the idea is that the typical index has only long positions. Thus, one creates the "perfectly hedged" benchmark by assuming that the short weights for a sector or sub-sector are the same as the long weights.

So, you can think of the minus sign that is inside the parenthesis with "w bar" (i.e., the benchmark sector weight) as changing the sign of the weight from positive to negative.

This ensures that the formula for asset allocation (referred to as sector selection in the Menchero reading) has its traditional results:

Value will be added when the manager overweights sectors that outperform the risk-free rate, and when the manager underweights sectors that underperform the risk-free rate
Value will be subtracted when the manager overweights sectors that underperform the risk-free rate, and when the manager underweights sectors that outperform the risk-free rate

Duties to One's Employer...?

2011-10-13T16:11:00.000-07:00

A Principles Level candidate asked me for an interpretation ofthe following ethics related question from one of the practice exams:

Angela Schneider, anequity analyst at Isotonic Asset Management, joins the board of trustees of theLightship Foundation, a large nonprofit organization. She does not informIsotonic about this commitment because her service on the Lightship board isuncompensated and will not interfere with her regular job. In addition, shethinks that Isotonic would exert pressure on her to influence Lightship'sselection of investment managers. Under the CIPM Association Standards ofProfessional Conduct, has Schneider violated her duty of loyalty to heremployer?

A. No

B. Yes, because she must act forthe benefit of Isotonic.

C. Yes, because she must disclosethat she has a conflict of interest with Isotonic.

My first comment is that I suggest that candidates respond to any typeof interpretative question with what they feel is the BEST answer. At the Expert Level, this applies toquestions on Ethics and questions related to the GIPS standards. It may seem like more than one of themultiple choice options available to you COULD be correct, but candidatesshould try to identify the best possible answer.

Next, I would eliminate answer “C.)” from consideration, because it isnot established that Ms. Schneider has a conflict of interest withIsotonic. It is stated that her work onLightship’s board of trustees will not interfere with her regular job. She is not required to use her position toinfluence Lightship’s selection of investment managers, and in fact, it may beadvisable for her not to do so. Dutiesto one’s employer does not cover taking advantage of one’s personalrelationships for the benefit of one’s employer.

I would also eliminate answer answer “B.)” from consideration. It is true that Ms. Schneider must act forthe benefit of Isotonic in her work activities, but her work on the board oftrustees of Isotonic is not part of her work activities

Thus, the correct answer is “A. No.”

Note: It might appear tocandidates that the actions of Ms. Schneider are a violation of the “AdditionalCompensation Arrangements” section of the Standards of Professional Conductunder Standard IV (Duties to Employers). I would say that answering “Yes” (i.e., choosing answer B. or C.)because of this should not be done for the following reasons:

· The question specifically points you to anothersection of the Standards of Professional Conduct; i.e., “Loyalty” – thus thequestion is not about “Additional Compensation Arrangements.”
Ms. Schneider is not compensated for her work onLightship’s board of trustees.

Expert Level Item Set #15 - Modified Dietz and Significant Cash Flows

2011-10-07T11:43:00.000-07:00

An Expert Level candidate asked some questions related to sample exam Item Set #15; the vignette is described below:

White Oaks Investment Management, a firm that claims to comply with the GIPS standards, manages an equity portfolio for the City of Kent’s pension plan. Patrick Lor, head of performance reporting, is reviewing Kent’s fourth-quarter portfolio activity and returns.

White Oaks uses the modified Dietz methodology to calculate monthly returns. The firm revalues portfolios when large external cash flows occur, and transfers cash and/or securities to or from temporary new accounts when there are significant cash flows. For the composite that includes the City of Kent’s portfolio, both large and significant cash flows are defined as cash flows that exceed ten percent of the portfolio’s market value.

The City of Kent contributed £6.5 million to its portfolio on 15 October and withdrew £22 million on 16 December.

The portfolio manager reallocated £20 million from the energy and gold sectors to the financials and health care sectors. The trading activity began on 20 November and was completed on 24 November.
Lor reviews Exhibit 1, which was prepared by a member of his staff.

In particular, the candidate's question was with respect to the second question in this Item Set:

Item Set 15, Question 2 (2010)

Calculated in accordance with the GIPS standards, the fourthquarter return for the City of Kent Pension portfolio is closest to:

( )A. 4.73%.

( )B. 5.86%.

( )C. 8.07%.

Theactivity with the temporary account is internal cash flow activity, notexternal cash flow activity. Thus, your return calculations don’t need toconsider it.

Thus youranswer should be 4.73%. This is the geometric linking of 3.688% forOctober, -2.804% for November, 0.9615% for the first sub-period in December and2.926% for the second sub-period in December.

In calculating the October return, the contribution on October 15th should be day-weighted within the 31 day month.

November does not have any external cash flows. The return can be calculated by simply taking

(EMV - BMV) / BMV, where EMV is ending market value and BMV is beginning market value.

In calculating the December return, the withdrawal on the 16th of December should be day-weighted within the 31 day month.

Expert Level - Sample Exam Question #15

2011-10-05T00:01:00.000-07:00

Question #15 from the Expert Level Sample Exam is with respect to the data in the table shown above, and reads:

15. Tom Styles, the head of performance measurement at Signal Investment Management, uses a sector allocation/security selection attribution model for both equity and fixed-income portfolios. The bond portfolio managers ask Styles to make his department’s fixed-income attribution analysis more meaningful. Styles uses the Campisi methodology to analyze the performance of a portfolio that contains US Treasury notes and bonds, corporate bonds, and high yield bonds. He prepares Exhibit 1 for the fixed-income portfolio managers’ review.

Which statement is most accurate? Over the evaluation period, the yield curve:

A. fell, and the portfolio’s duration was longer than the benchmark’s duration.
B. fell, and the portfolio’s duration was shorter than the benchmark’s duration.
C. rose, and the portfolio’s duration was longer than the benchmark’s duration.

There are two things you need to determine here:

Did interest rates rise or fall, which would cause a price change that was negative or positive, respectively?
Did the portfolio have a better yield curve positioning than the benchmark, given the change in interest rates?

You can tell that interest rates fell because the Treasury return is positive (for both the portfolio and benchmark). The Treasury return is the portion of the price return that is due to changes in Treasury interest rates. The fact that this is a positive number means that Treasury interest rates declined during the period, making existing Treasuries look more attractive, resulting in their prices going up, and affecting a positive return. This concept is covered in the second reading in Study Session VI, which covers the Campisi attribution model.

The fact that the benchmark’s Treasury effect is higher than the portfolio’s Treasury effect means that the benchmark was better positioned (from a duration standpoint) to respond to the changes in Treasury interest rates over the period than the portfolio. From the first reading in Study Session VI, which covers the Fong-Pearson-Vasicek model, candidate should understand that holding long duration portfolios during periods of decreasing interest rates will add value, as will holding short duration portfolios during periods of increasing interest rates. Thus, the benchmark’s higher Treasury effect while interest rates decreased is a sign that the portfolio’s duration was less than (shorter than) the benchmark’s.

Thus, the correct answer is B.

Calculating Standard Deviation Using the Stats Worksheet (TI BA II Plus)

2011-10-03T21:50:00.000-07:00

CIPM candidates are required to be able to calculate standard deviations for several purposes, including:

the dispersion of annual portfolio returns within a composite (internal dispersion)
the variability of a composite's past 36 months of returns (external dispersion)
the ex-post variability of a portfolio's historical returns (standard deviation)
the ex-post variability of a portfolio's historical excess returns vs. a benchmark (tracking error)

Calculating standard deviation can be, however, quite tedious with a calculator. If one does the calculation "long hand" style, it requires the following steps:

Finding the average of all return observations under consideration.
Measuring the distance of each return observation from the average return.
Squaring the distances from the average return.
Summing the squares.
Dividing the sum by the number of observations.
Taking the square root.

In order to save time, candidates that are using the Texas Instruments BA II Plus calculator can make use of the calculator's "Statistics Worksheet," which can calculate standard deviation with just a few keystrokes.

For example, consider the following history of returns:

January 2010: 7.22%
February 2010: 5.19%
March 2010: 8.88%
April 2010: 1.13%
May 2010: 17.5%
June 2010: 3.70%
July 2010: 2.50%
August 2010: 0.55%
September 2010: -5.17%
October 2010: 3.33%
November 2010: 1.07%
December 2010: 8.25%
January 2011: 5.45%
February 2011: 2.27%
March 2011: 8.00%

To access the calculator's statistics worksheet, type [2ND] [7]. Note that the "2nd" function of the [7] key is "DATA."

The statistics worksheet remembers any past entries until they are cleared, so you may need to clear previous entries. If this is the case, once you have accessed the statistics worksheet, type [2nd] [CE/C] (note that the 2nd function of the [CE/C] key is "CLR Work").

When the calculator is ready, you should see the following on the display: "X01 0."

The calculator can accept two series of data: an "X" series and a "Y" series. I suggest that you use the "X" series. So, X01 is the first item, X02 is the second, and so on. Thus, you will need to skip the prompts for "Y" values.

Given this, the following keystrokes are required to enter the above returns into the worksheet:

7.22 [ENTER][DOWN ARROW][DOWN ARROW]
5.19 [ENTER][DOWN ARROW][DOWN ARROW]
1.13 [ENTER][DOWN ARROW][DOWN ARROW]
17.5 [ENTER][DOWN ARROW][DOWN ARROW]
3.70 [ENTER][DOWN ARROW][DOWN ARROW]
2.50 [ENTER][DOWN ARROW][DOWN ARROW]
0.55 [ENTER][DOWN ARROW][DOWN ARROW]
-5.17 [ENTER][DOWN ARROW][DOWN ARROW]
3.33 [ENTER][DOWN ARROW][DOWN ARROW]
1.07 [ENTER][DOWN ARROW][DOWN ARROW]
8.25 [ENTER][DOWN ARROW][DOWN ARROW]
5.45 [ENTER][DOWN ARROW][DOWN ARROW]
2.27 [ENTER][DOWN ARROW][DOWN ARROW]
8.00 [ENTER][DOWN ARROW][DOWN ARROW]

At this point, you are ready to do statistical calculations, including standard deviation. To access these calculations, type [2ND][8] (note that the "2nd" function of the [8] key is "STAT." The calculator should respond with "LIN" which indicates that the calculator is in "linear regression mode. This is what you need. The calculator also does other regression modes (exponential, logarithmic, etc.). If something other than "LIN" appears, type [2ND][ENTER] until you see "LIN."

At this point you may use the [DOWN ARROW] and the [UP ARROW] to cursor through the statistical calculations.

The first item is the number of observations in the worksheet (in the "X" series).
The next item is the average observation (in the "X" series).
The next item is the sample standard deviation (in the "X" series).
The next item is the population standard deviation, which is the item you need (in the "X" series).

If you have entered the keystrokes correctly, you should see that the standard deviation is 4.94.

Reading the keystrokes in this post may make it sound somewhat difficult, but if you practice this method, I am sure you will find it much faster than calculating standard deviations "long hand."

Having said this, I do recommend you calculate it both ways (using the statistics worksheet and "long hand") for the maximum learning experience.

Happy calculating!

CIPM Test Prep Q&A Webcast - October 3, 2011!

2011-10-01T21:16:00.000-07:00

On this coming Monday, October 3, 2011, I will be hosting our next webcast, which will be an open Q & A (question and answer) session for candidates preparing for the CIPM exams (both Principles Level and Expert Level).

The session is free for CIPM candidates that attended one of The Spaulding Group's prep classes, and is also offered at a substantial discount to any other interested parties.

The webcast will be at 9:00 AM Pacific time, 12:00 noon Eastern time, 5:00 PM GMT and 10:00 PM GST. It will run for two hours.

An Internal Rate of Return exercise...

2011-09-01T08:24:00.000-07:00

A CIPM Expert Level candidate sent me the following question, asking what are the proper keystrokes to obtain the solution:

The Millers deposited $50,000 into their account on 1 May 2005 and another $40,000 on 1 July 2005. The portfolio also received and reinvested dividends of $30,000 on 1 July, plus another $30,000 on 31 December. The Miller's investment adviser, Greenbush Investments, uses a daily pricing system that shows account values (inclusive of dividends and contributions) of $2,375,000 and $2,460,000 on 1 May and 1 July, respectively. The account was valued at $2,225,000 on 1 January 2005 and at $2,445,000 on 31 December 2005.

What is the annual internal rate of return?

First, I suggest that readers of this blog review my post from a few months ago suggesting a series of steps to solve internal rate of return problems. That post is here.

Next, we should identify the important information in this problem; i.e., the cash flows that must be entered into the calculator - and those that should be ignored. The important cash flows are:

the initial market value of $2,225,000 on 1/1/2005
the contribution of $50,000 on 5/1/2005
the contribution of $40,000 on 7/1/2005
the ending market value of $2,445,000 on 12/31/2005

You can ignore the dividends that are described because they are "reinvested" - this means they remain in the portfolio and are not an external cash flow. If they were "not reinvested," that would mean that they should be treated as withdrawals at the time of payment... but that is not the case here.

You can also ignore the other valuations that are given. With internal rate of return calculations, only the initial value and the ending value are needed.

In order to enter this into your financial calculator, you will need to evenly space the cash flows (in time) and "zero fill" the empty periods. In this problem, you can assume monthly occurring cash flows if you treat the initial market value as being for 12/31/2004, and the contributions as occurring on 4/30/2005 and 6/30/2005 (rather than 5/1/2005 and 7/1/2005).

The "zero filled" cash flows will be on the following dates: 1/31, 2/28, 3/31, 7/31, 8/31, 9/30, 10/31 and 11/30.

Thus, the following keystrokes may be used (TI BA II Plus calculator):

[CF][2nd][CLR WORK] Clears cash flow worksheet

-2225000[ENTER] Enters 2,225,000 as CF0

[down arrow] 0 [ENTER] Enters 0 as CF1

[down arrow] 3 [ENTER] The frequency of this flow is three times

[down arrow] -50000 [ENTER] Enters 50,000 as CF2

[down arrow] 1 [ENTER] The frequency of this flow is once

[down arrow] 0 [ENTER] Enters 0 as CF3

[down arrow] 1 [ENTER] The frequency of this flow is once

[down arrow] -40000 [ENTER] Enters 40,000 as CF4

[down arrow] 1 [ENTER] The frequency of this flow is once

[down arrow] 0 [ENTER] Enters 0 as CF5

[down arrow] 5 [ENTER] The frequency of this flow is five times

[down arrow] 2445000 [ENTER] Enters 2,445,000 as CF6

[down arrow] 1 [ENTER] The frequency of this flow is once

[IRR][CPT] Computes the IRR

At this point, the calculator should tell you the solution is 0.4636%. But, this is a monthly return, because the spacing of our cash flows was monthly. We now need to convert this to an annual return. To do this, do the following steps:

divide by 100 (converting the percentage to a decimal)
add 1 (creating a wealth relative)
raise the result of the last step to the 12th power
subtract 1
multiply by 100

This should give you an annual return of 5.70%

Upcoming Webinar - Excel Tips & Tricks for Performance Professionals

2011-08-12T04:00:00.000-07:00

Granted, CIPM candidates are not able to use Microsoft Excel during their examinations. But one of the points I make to candidates that attend our CIPM Exam Prep Classes is that I do strongly believe that Microsoft Excel (or a similar spreadsheet software product) can be used as a powerful study tool.

In today's world, we've seen more and more that people learn more when they have a tactile experience with their curriculum. Also, we are typically more accustomed to using spreadsheets to perform calculations than calculators. Thus, I encourage candidates to use spreadsheets during their study time for any calculations they are required to learn, especially in the areas of attribution and risk.

Thus, I want to mention that there is a great learning opportunity available to CIPM candidates (and performance professionals in general)! My colleague, Jed Schneider, CIPM, FRM will be conducting a webinar entitled Excel Tips and Tricks for Performance Professionals. Jed will be conducting the webcast along with another performance professional that I highly respect, Neil Riddles, CFA, CIPM.

We are seeing a very high number of people sign up for this event, and I believe it is one that candidates will not want to miss!

Carve-outs: the Possibilities for Periods after 1 Jan 2010

2011-04-28T08:56:00.000-07:00

A CIPM Principles Level candidate emailed the following question to me:

I was wondering if you could answer this question for me:

For Session 8 Q&A 7 Composite definition, how can carve-outs, included in composites prior to January 1, 2010, without separately managed cash be included in the composites after January 1, 2010? Shouldn’t all carve-outs that don’t have separately managed cash be excluded including carve-outs with cash allocation starting January 1, 2010 even if they were in a composite before? Please clarify the sentence below:

“As a result some composites may include carve-outs (managed separately with their own cash balance) after 1 January 2010 and some may not.”

Perhaps the wording used in the curriculum is confusing here, but the statement is making the point that, for periods after 1 January 2010, some of a fim's composites may include carve-outs while other composites do not include carve-outs. Any carve-outs included in composites after 1 January 2010 must use cash actually managed cash for the carve-out.

Keep in mind that for periods starting on/after 1 Jan 2010, firms have the following options with respect to the use of carve-outs:

1) Stop using carve-outs: this would reduce composite assets going forward. Firms could continue to show carve-outs in their supplemental information, if desired. I'd recommend that if the firm goes with this approach, it is a significant event worthy of disclosure, in the context of GIPS provision 4.A.14.

2) Establish separate cash accounts: You would have cash accounts created for each asset class (e.g., for equities, fixed income, cash). Your accounting system would need to be able to direct cash into and out of each segment (e.g., for purchases, sales, income), appropriate to that asset class. Additionally, any account-level contributions / withdrawals will need to be allocated to these separate cash accounts.

3) Establish separate sub-accounts: If your accounting system will allow it, simply” create separate sub-accounts for each asset class. The accounting system would need to properly handle all cash movements into and out of these separate cash accounts (for trades, income). You would also need to handle allocation of external flows, and reconciliation may be a challenge.

4) Establish separate accounts: Most portfolio accounting systems should be able handle this approach. The accounting system would need to properly handle all cash movements into and out of these separate cash accounts (for trades, income). You would need to handle allocation of external flows. Reconciliation may be a challenge - the custodian wouldn't necessarily match your account level details. An ability to consolidate accounts would be needed. Client reporting might be impacted.

5) Stop complying with GIPS: this is definitely not a desirable or intended option for firms to take. But, a possibility!

Options are Physical Securities!

2011-04-27T22:38:00.000-07:00

There are several ways that options differ from futures contracts. One of those ways in which they differ is that options are securities that must be acquired in exchange for physical cash. By contrast, in acquiring a futures contract position, one does not need to pay cash - they only obligate themselves to ultimately pay the cash value of the futures position at contract expiration.

Options contracts may be exchange listed or over-the-counter (OTC) - but in either case, they trade at some price. The cost basis of the option contract must then be deducted from physical cash at the time option positions are acquired. This is an important point to keep in mind when dealing with options at the CIPM Expert Level - your return calculations will not be correct unless you remember to reduce portfolio cash by the cost basis of the options traded.

Actual vs. Model Investment Management Fees

2011-04-27T21:58:00.000-07:00

A CIPM candidate emailed me a question today regarding one of the exercises found in the Principles Level, in the interactive portion of the curriculum materials. This question is found in Study Session VII and is question 10:

Langerton Asset Management has complete historical information about the fees
incurred by the portfolios in the domestic large cap equity composite. Langerton
recently increased its investment management fees. To calculate net-of-fees composite
returns, Langerton must reduce the domestic large cap equity composite's gross-offees
returns by the:

a) highest investment management fee in the current fee schedule
b) actual investment management fees incurred by the portfolios in the composite
c) highest investment management fee incurred in each period by the portfolios in the composite

The exercise indicates to select the "best" answer.

The answer is b). But why?

Here is my interpretation:

- They indicated to select the "best" answer. This is an acknowledgment that more than one answer could be correct. It is also an indication that if more than one answer is correct, in the opinion of the question writers, one of the correct answers is more valid (i.e., better) than the rest of the correct answers.

- GIPS allows compliant firms to calculate net-of-fees performance in a couple of different ways: you may reduce the gross-of-fees return by actual management fees or, alternatively, you may reduce the gross-of-fees return by model management fees.

Unfortunately, there is no guidance at this time that explains what a model management fee is. Whenever the question of what is meant by model management fee is asked of me, I say the safest thing is to use the highest management fee.

Given this, either a) or c) could be correct answers, in my opinion. Both answers provide a means of calculating a model management fee.

Having said all of this, I think it is fair to say that GIPS does not indicate a preference for the use of actual management fees over model management fees. Thus it could seem that either approach is fine and equally valid. But, my interpretation here is that they expect candidates to understand that actual performance is better than estimated performance, and the use of model management fees is more of an estimate of performance results than the use of actual management fees. Thus, b) is the best answer, because it provides for a net-of-fees return that is the best representation of the actual net-of-fees return for the composite in question.

I welcome other interpretations on this, so please feel free to comment.

CIPM Expert Level - Sample Exam Solution #7

2011-04-16T23:04:00.000-07:00

One of the participants in last week's webinar on CIPM Q & A asked me to explain the solution to the question #7 from the sample exam questions found on the CFA Institute's CIPM Program page (). The vignette and question follow below:

Longitudinal Asset Management is a US-based portfolio manager investing in international equities. One of the firm’s portfolios is invested entirely in Canadian and United Kingdom equities. At the beginning of an evaluation period, the market values of the portfolio’s Canadian and UK segments are 5,000,000 Canadian dollars (CAD) and 3,000,000 pounds sterling (GBP), respectively. At the prevailing exchange rates, one CAD equals 0.80 US dollars (USD), and one GBP equals 2.00 USD.
Excluding dividend income, at the end of the period the Canadian equities are valued at CAD 5,300,000 and the UK equities are valued at GBP 2,880,000. The CAD now equals 0.90 USD while the GBP now equals 1.90 USD. Dividend payments of CAD 100,000 and GBP 180,000, respectively, are received at the prevailing exchange rates on the last day of the period.

7. The currency component of the Canadian equities segment return in USD is closest to
A. 9.0%
B. 12.5%%.
C. 13.5%.

The relationship that you should understand to solve this question is that currency return is not simply the exchange rate return. Rather, exchange rate return compounds the local return components (capital yield and income yield). That is,

c = s * (1 + p + y)

where c is the currency return, s is the exchange rate return, p is the price return in local currency terms (i.e., the capital return) and y is the income return.

The exchange rate return is (0.9 - 0.8) / (0.8) = .125.

The capital return is (5,300,000 - 5,000,000) / 5,000,000 = 6% = .06.

The income return is 100,000 / 5,000,000 = 2% = .02.

Thus the currency component of the Canadian equities segment return is:

.125 * (1 + .06 + .02) = 13.5%

Steps for calculating IRR

2011-04-14T23:22:00.000-07:00

The following steps may be used to calculate internal rate of return using one of the financial calculators (HP 12C and TI BA II Plus):

1. Identify all external cash flows, including beginning and ending market values, and arrange them in chronological order.

2. Arrange the cash flows so that they are evenly spaced with respect to time. The financial calculators expect cash flows to occur at a regular frequency, so the cash flows entered must be evenly spaced, with zero cash flows used to fill in any missing data. I will describe how this can be done below.

3. Create the present value equation, equating the sum of the present value of outflows (beginning market value and any contributions) with the sum of the present value of in-flows (ending market values, and any withdrawals). I recommend ordering cash flows on each side of the equation in chronological order, from the first through to the last.

4. Identify simultaneously occurring cash flows. These are cash flows that occur on the same date, including both outflows and in-flows. These will be netted for purposes of entry into the financial calculator.

5. Using the appropriate keystrokes, enter the cash flows into the financial calculator’s cash flow worksheet, and compute the IRR.

6. The solution obtained in step 5 will be an internal rate of return for the interval of the cash flow spacing (step 2). Using exponents, convert the internal rate of return to a return for the desired period.

about Roots and Exponents...

2011-04-10T17:46:00.000-07:00

Sometimes when we are calculating returns, we need to know the meanings of roots and exponents. This may be especially true when we have to enter things on the calculator, like CIPM candidates are required to do on exams.

In mathematics, the n-th root of a number x is a number r which, when raised to the power of n, equals to x. For example, the 3rd root of 343 is 7. This means that 7 times 7 times 7 = 343.

Exponentiation is a mathematical operation, expressed as a raised to the n-th power, involving two numbers, the base a and the exponent n. When n is a positive integer, exponentiation corresponds to repeated multiplication. Using the prior example, 7 raised to the third power is 343.

Roots are special cases of exponentiation, where the exponent is a fraction. That is to say, the nth root of x is the same thing as raising x to the 1/n power.

For example, the third root (aka the 3rd root or cube root) of 343 is the same thing as raising 343 to the 1/3 power.

Why is this important? On some calculators, you can look at the math from either a root-taking point of view or an exponentiation point of view. But, for the calculators that are allowed for the CIPM exams, you must do things by taking an exponentation point of view, because there is no button that corresponds to taking "the x-th root of y."

For example, let's say that you had to calculate an IRR, and your calculator result comes out as a quarterly number but the answer requires an annual return. Suppose the quarterly return was 5.5%. In order to obtain the appropriate annual return, you must do the following steps:

1. make the return a decimal: 0.055
2. create the corresponding wealth relative by adding 1: this makes 1.055
3. raise 1.055 to the 4th power: this yields 1.2388
4. subtract 1: this yields 0.2388
5. make the decimal number a percentage: thus, the final answer is 23.88%

If you were thinking about this from a root-taking standpoint, would say that the return represents 1/4 of a year (i.e., 0.25 years), thus you could take the .25th root of 1.055, which is equivalent to raising 1.055 to the 4th power.

CIPM Test Prep Q & A with John D. Simpson, CIPM

2011-04-04T23:07:00.000-07:00

CIPM Test Prep Q & A with John D. Simpson, CIPM

Join us for a Webinar on April 12

Space is limited.
Reserve your Webinar seat now at:
https://www2.gotomeeting.com/register/769471026

Join us on April 12, 2011 as John D. Simpson, CIPM tackles your last minute questions as you prepare for the rigorous CIPM examinations. During this session you will get study tips from The Spaulding Group's specialists that have been through the study and exam process. This class is free to any CIPM candidate that attended our classes, Performance Measurement Forum members, TSG verification clients and discounted for everyone else.

Title: CIPM Test Prep Q & A with John D. Simpson, CIPM
Date: Tuesday, April 12, 2011
Time: 12:00 PM - 2:00 PM EDT

After registering you will receive a confirmation email containing information about joining the Webinar.

System Requirements
PC-based attendees
Required: Windows® 7, Vista, XP or 2003 Server

Macintosh®-based attendees
Required: Mac OS® X 10.4.11 (Tiger®) or newer

CIPM Expert Level - Sample Exam Solutions, #5 and #6

2011-04-03T20:35:00.000-07:00

One of the students in my CIPM Expert Level Prep Classes asked me to explain the solution to the questions #5 and #6 from the sample exam questions found on the CFA Institute's CIPM Program page (). The vignette and questions follow below:

Longitudinal Asset Management is a US-based portfolio manager investing in international equities. One of the firm’s portfolios is invested entirely in Canadian and United Kingdom equities. At the beginning of an evaluation period, the market values of the portfolio’s Canadian and UK segments are 5,000,000 Canadian dollars (CAD) and 3,000,000 pounds sterling (GBP), respectively. At the prevailing exchange rates, one CAD equals 0.80 US dollars (USD), and one GBP equals 2.00 USD.
Excluding dividend income, at the end of the period the Canadian equities are valued at CAD 5,300,000 and the UK equities are valued at GBP 2,880,000. The CAD now equals 0.90 USD while the GBP now equals 1.90 USD. Dividend payments of CAD 100,000 and GBP 180,000, respectively, are received at the prevailing exchange rates on the last day of the period.

5. The total return of the portfolio’s UK equities segment expressed in base currency (USD) is closest to:
A. –8.8%.
B. –5.1%.
C. –3.1%.

6. The portfolio’s total return, expressed in base currency, is the sum of the capital gain, yield, and currency components of return. In this framework, the capital gain component of the entire portfolio’s total return is closest to:
A. 0.00%.
B. 1.00%.
C. 2.42%.

Solution to #5: First important point is to realize that total return is equal to change in value plus period income, divided by beginning value. This is the holding period return that is referred to multiple times in the Expert Level curriculum:

HPR = (EMV - BMV - D) / BMV

where HPR is the holding period return, EMV is the ending value, BMV is the beginning value and D is the period income.

The starting value of the UK equities is 3,000,000 GBP, which converts to 6,000,000 USD at the beginning of period exchange rate of 1 GBP = 2 USD.

The ending value of the UK equities is 2,880,000 GBP for the stocks, plus the dividend income of 180,000 GBP, for a total of 3,060,000 GBP. This converts to 5,814,000 USD at the end of period exchange rate of 1 GBP = 1.9 USD.

Thus, the total return of the portfolio's UK equities is (5,814,000 - 6,000,000) / 6,000,000. This amounts to a return of -3.1%.

Solution to #6: For this problem, we are focused on the capital gain component of the portfolio's total return. Thus, we ignore the income that was earned (as well as the currency component of the total return), and focus on the equities.

At the start of the period, there are two positions, the UK equities and the CA equities:

- the value of 3,000,000 GBP converts to 6,000,000 USD at the exchange rate of 1 GBP = 2 USD.
- the value of 5,000,000 CAD converts to 4,000,000 USD at the exchange rate of 1 CAD = .8 USD.

Thus the starting value of portfolio is 6,000,000 + 4,000,000 = 10,000,000 USD.

At the end of the period:

- the value of 2,880,000 GBP converts to 5,760,000 USD at the exchange rate of 1 GBP = 2.0 USD.
- the value of 5,300,000 CAD converts to 4,240,000 USD at the exchange rate of 1 CAD = .8 USD.

Thus the ending value of the portfolio is 5,760,000 + 4,240,000 = 10,000,000 USD.

Given that the starting value of the portfolio equals the ending value of the portfolio, it should be straightforward that the total return is 0.00%.

About Modified IRR... (don't think too hard)

2011-04-02T11:25:00.000-07:00

Over the last couple of weeks, I have been teaching our prep courses for the CIPM exams. While teaching the Principles Level course, I came across a sentence that caused some confusion:

"The Modified IRR method is another estimation approach acceptable prior to 1 January 2011."

This sentence appears in the Study Session II document called "Overview of GIPS Principles," at the bottom of the page numbered as 22.

The sentence caused me to stop because it seemed (to me) to imply that the Modified Internal Rate of Return is not an acceptable estimation approach for time-weighted return calculations for firms that claim compliance with the Global Investment Performance Standards (GIPS). I know, of course, that this is not the case. GIPS provision 2.A.2.b requires if compliant firms are not revaluing the portfolio on the date of every cash flow, then they must use a method that adjusts for daily-weighted cash flows. Both Principles Level and Expert Level candidates should be aware of this provision. Additionally, Expert Level candidates should also be aware that the Guidance Statement on Calculation Methodology points out that the Modified BAI method is acceptable - this is essentially another name for the Modified IRR method.

I asked the CIPM Prep Providers program about the sentence in question, and they explained to me that the sentence does not actually say that the Modified IRR method is not acceptable after January 1, 2011 - it merely states that it is acceptable before that date! In re-reading the sentence, I agreed that what they said is true... and that I read too much into the sentence.

Having said that, I suggested that the sentence could possibly be misconstrued by many, and they did indicate that they will point this out in the errata. So, another good reason for candidates to periodically check the curriculum errata, as clarifications may be made there in addition to corrections!

"Calculating" the hedge ratio...?

2010-12-22T15:38:00.001-08:00

When I teach The Spaulding Group's prep courses for the CIPM exams, I always advise candidates to carefully consider the Learning Outcome Statements in each study session, as these statements describe the subject matter that candidates are required to master. In particular, I tell the candidates to focus on the verbs in each statement (e.g., compare, contrast, state, calculate, describe), as I see these as really the centerpiece of each statement.

At the Expert Level, there is a Learning Outcome Statement in Study Session II that reads:

Calculate the hedge ratio (delta) of an option and conclude whether the option is in-the-money, at-the-money or out-of-the money

The word "calculate" has a fairly specific meaning in my mind, but I decided to consult with Merriam Webster:

transitive verb

1a : to determine by mathematical processes <calculate the rate of acceleration>
1b : to reckon by exercise of practical judgment : estimate <calculate the likelihood of success>
1c : to solve or probe the meaning of : figure out calculate his expression — Hugh MacLennan>

2a: to design or adapt for a purpose calculated the timing of his arrival for maximum impact>

3a : to judge to be true or probable b : intend calculate to do it or perish in the attempt — Mark Twain>

intransitive verb
1a : to make a calculation
1b : to forecast consequences
2a : count, rely

In checking the list of formulae for the Expert Level, I don't see a specific formula for the hedge ratio, and I don't see one in the assigned readings. Thus, I don't think "calculate" is what is intended - at least not in the common, every day usage of the word.

Having said that, it is important to understand the characteristics of the hedge ratio (of a call option) in certain situations:

Hedge ratio is a function of stock price, term of the option contract, the expected variance of the underlying stock's price, and the risk-free rate

If the underlying stock's price is considerably below the option's strike price (i.e., the option is deeply "out-of-the-money"), the hedge ratio approaches zero and it is not desirable to exercise the option.

If the underlying stock's price is "at-the-money" (i.e., the stock price and the strike price of the option are approximately equal), the hedge ratio is close to .5, as it makes little difference if the stock is acquired via market purchase or by exercising the call option

If the option is deep "in-the-money", the hedge ratio approaches 1, and it is advantageous to acquire the underlying stock by exercising the option.

Note that all of this describes call options only (i.e., options where the holder has the right to purchase the underlying security). Put options are not currently covered in the CIPM curriculum.

Note: The graphic above illustrates Bloom's Taxonomy, upon which the Learning Outcome Statements of the CIPM curriculum are based.

Did the Expert Level Just Get *More* Difficult?

2010-12-20T15:59:00.000-08:00

Well, I'm not sure if it got harder... but certainly there is quite a bit more content?

I am in the process of updating the materials I use to teach The Spaulding Group's CIPM Prep Classes (Principles and Expert Levels), and in reviewing the 2011 curriculum, I see that some of the content has shifted from the Principles Level curriculum to the Expert Level curriculum.

I suppose that's a "good news / bad news" thing for new CIPM candidates. The good news is that the Principles Level curriculum is a bit lighter, content wise, as some subjects are now deferred to the Expert Level. But, the bad news, there's more information to master at the
Expert Level than there was in the past.

The following subjects have been removed from the Principles Level curriculum, and are now entirely covered at the Expert level:

real estate
private equity
(most of) verification
GIPS standards related to model portfolios
GIPS standards related to switching of portfolios between composites
GIPS standards related to measuring composite dispersion
GIPS standards related to portability of past performance
In prior examination windows, I would characterize what was required of candidates for these topics as essentially learning the provisions at the Principles Level, and being able to apply the related guidance and interpretations (as well as deal with some additional calculations) at the Expert Level. Now all of this will be covered at the Expert Level.

While this change does not increase the overall content, it does make the Expert Level more "packed."

So, CIPM candidates, be aware! (Details can be found here.)

P.S. I have received some lighthearted flak from candidates for making this suggestion at conferences, but I wonder aloud again if it would be worthwhile for the CIPM Body of Knowledge to be covered in three (3) exams rather than two...

Is the S&P 500 actively managed?

2010-11-30T10:49:00.000-08:00

Earlier this week, my boss, David Spaulding surmised on his blog about the possibility that the mere existence of indexes may be a reason for "above average" performance, as changes in index constituents often results in trading in the newly added stocks, which often causes their prices to rise.

The question of whether the Standard & Poor's 500 is actually a managed portfolio is addressed in one of the "Benchmarks" study session readings at the CIPM Expert Level. The reading, authored by Laurence B. Siegel, refers to some research done by Sandy Rattray and Pravin Manglani. The article on that research is not required reading for CIPM candidates, but it may be of interest, and can be found online here.

The GRAP attribution linking formula

2010-09-13T21:16:00.000-07:00
At the Expert Level, CIPM candidates are required to learn a few of the more commonly used linking methodologies for smoothing the attribution effects that come from arithmetic models. The required methodologies include:

Cariño
Menchero
GRAP

Of these methods, the GRAP method is my personal favorite because of it's simplicity... which may not be apparent looking at the formula! Upon first glance, the GRAP formula, which appears above, may seem intimidating for a couple of reasons:

It uses three "series" one summation series a two multiplication series.

The three series have different indexes (T=1 through N, t = 1 through T-1, and t = T+1 through N).

When teaching the GRAP method, I find that it is easier to explain what it does, effectively, rather than explaining the formula.

Consider a situation where we are linking together monthly attribution effects for the first six months of the calendar year (January through June). Let's consider how we obtain the "G" factor that we will use to smooth the attribution effects for the month of April. Basically, what the GRAP formula tells us is that:

The excess return is the sum of the "smoothed" attribution effects

We obtain the smoothed attribution effects by multiplying the original attribution effects by the "G" factor

The G factor for a particular month is a combination of portfolio returns and benchmark returns for the periods being linked together.

In our example, we are smoothing the attribution effects for April. This will be done by multiplying together:
the unitized portfolio returns for the months preceding April (January, February, March)
the unitized benchmark returns for the months coming after April (May, June)

Thus, the following formula yields the G factor that we can use to smooth the April attribution effects:

Thus, the GRAP formula is very easy to remember, and much simpler to use than the Menchero or Cariño methods.

GIPS: "in transition" assets

2010-08-25T21:32:00.000-07:00

Recently I received a question from one of our verification clients regarding what I call "in transition" assets - basically accounts that are in the process of moving from one category to another with respect to the firm's GIPS compliant performance presentations. In answering, I thought that this is the type of interpretative question that could appear in some form on the CIPM Expert Level exam.

Basically, the so-called “in transition” assets must be part of the firm assets on the firm's performance presentations, but not part of composite assets. In particular, the points in time where you need to worry about these are at the end of the year, as GIPS provision 5.A.1.c (GIPS 2005) requires the presentation to include information on the amount of firm assets and composite assets at the end of each annual period.

Examples of “in transition” assets include:

An account that was GIPS discretionary, but the client has indicated they are closing they are closing the account (thus discretion can be inferred to have been lost) but the account had not been fully liquidated/closed at the end of the year. For example, if a client called to say they were leaving the firm on December 17, 2009, but the account had not been liquidated until January 5^th. Assuming the period for performance calculations is monthly, the account is not part of its composite for the month of December, but is part of the firm assets.

A new account to the firm, that will become GIPS discretionary, but has not met the inclusion requirements yet, based on the firm’s documented GIPS policies. For example, assume an account is opened on December 17, 2009, but the firm’s policy is to include new accounts in composites starting with the first full month under management. Thus, the account would not appear in the composite’s performance until the month of January 2010, but it would be part of the firm assets for the end of 2009.

An account that is changing composites (either due to a change in client mandate or a composite redefinition; see GIPS provision 3.A.5), assuming the change occurs on December 17, 2009 but the firm’s or the new composite’s documented inclusion policy is to include the account in the new composite in the first full month under management (a la a new account). Such an account would not be part of composite assets for the month of December, would be reflected in the new composite’s return for January 2010, and be part of the firm assets for the end of 2009.

Similar logic should be applied to:

Actual, discretionary, non-fee-paying accounts that the firm has elected to exclude from composites.

Legally discretionary accounts that are GIPS non-discretionary accounts (based on the firm’s documented policy on discretion).

(The picture at the top of this post is the cover from John Coltrane's album "Transition." Seemed a fitting reference from a few respects. First, the album came between Coltrane's quartet period of somewhat traditional jazz, and the last major period of his life which featured more experimental styles. Also, the album was released after Coltrane's death, when one might imagine that Coltrane was making his transition from his earthly life to his spiritual one!)

Why Do We Call it "Time-Weighted?"

2010-07-25T02:48:00.000-07:00

Recently, my boss David Spaulding commented regarding the origin of the term "time-weighted return."

The CIPM curriculum at the Principles Level gives a description as to the origin of the name. Unfortunately, an original source is not cited. But, I remind candidates of this description given in the curriculum, as they are responsible for knowing this information.

I quote from the candidate reading, Chapter 12, Evaluating Portfolio Performance:

"The TWR derives its name from the fact that each subperiod return within the full evaluation period receives a weight proportional to the length of the subperiod relative to the length of the full evaluation period. That relationship becomes apparent if each subperiod return is expressed as the cumulative return over smaller time units."

The curriculum goes on to describe an example of a time-weighted return calculated for a month as follows:

beginning value - 1,000,000
contribution of 30,000 on the 5th of the month; market value at that time is 1,045,000
contribution of 20,000 on the 16th of the month; market value at that time is 1,060,000
ending value is 1,080,000
The two external cash flows break the month into 3 sub-periods, with returns as follows:

rt,1 = [($1,045,000 − $30,000) − $1,000,000]/$1,000,000 = 1.50%
rt,2 = [($1,060,000 − $20,000) − $1,045,000]/$1,045,000 = -0.48%
rt,3 = ($1,080,000 − $1,060,000)/$1,060,000 = 1.89%

Thus, the time-weighted return for the month is the geometric linking of the subperiod returns: rtwr = (1 + 0.0150) × (1 + −0.0048) × (1 + 0.0189) − 1 = 2.92%

The reading goes on to point out that one could calculate a daily compounded return for each subperiod:

period 1 corresponds to a daily compounded return of 0.30% for 5 days
period 2 corresponds to a daily compounded return of -0.04% for 11 days
period 3 corresponds to a daily compounded return of 0.13% for 14 days

Thus, the time-weighting, the curriculum indicates, corresponds to the exponent used to compound the daily returns:

rtwr = (1 + 0.0030)**5 × (1 + −0.0004)**11 × (1 + 0.0013)**14 – 1 = 2.92%

The Expanding CIPM Body of Knowledge

2010-06-17T19:48:00.000-07:00
On next Friday (June 25th at 9:00 a.m. Pacific time), I will be hosting a webinar covering the changes (really, the additions) that have occurred to the Certificate in Investment Performance Measurement (CIPM) program since the first examination window.

As Dave Spaulding mentioned on his blog (Investment Performance Guy) today, Dave and I were "pioneers" as we were part of the first group to enroll for the exams and earn the certification. Back in 2004, The Spaulding Group and the Performance Measurement Forum formed a Blue Ribbon Committee that kicked off the process of developing a certification program for performance professionals. We have offered our training classes since the initial enrollment periods for the CIPM (then called CGIPS) exams. It has been very gratifying to teach our CIPM classes and see our students succeed with a significantly higher pass rate than the general population.

This particular webinar is actually targeted at CIPM certificants. As we learn at the Principles Level, the Body of Knowledge that is required to do our work well and serve our clients is constantly evolving. Also, certificants are required to update their body of knowledge by meeting a Mandatory Continuing Education requirement (MCE). We are offering the webinar to help certificants satisfy their MCD requirements.

To sign up, please contact Patrick Fowler.

"Failure to prepare is preparing to fail."

2010-06-09T01:34:00.000-07:00

Last week, the world lost one of (in my opinion) the most influential teachers in sports (and elsewhere), the legendary Coach John Wooden, who led my alma mater, UCLA to an unsurpassed 10 national championships in men's college basketball. Coach Wooden (shown above with Lew Alcindor, who later changed his name to Kareem Abdul-Jabbar) is famous for many quotations, but one that applies to CIPM candidates right now is in the title of this blog post: "Failure to prepare is preparing to fail."

The examination window for the Fall 2010 period is now open (and has been since May 1st), yet the exams will not happen until October, which I'm sure seems to be far off in the future to some.

I strongly urge candidates to begin studying for the CIPM exams as soon as possible. The curriculum is broad, and learning the material over time (rather than cramming in the final weeks before the exam) will help you obtain a deeper understanding of the material, and give you a greater chance of success (i.e., passing the exams). Do not underestimate the number of hours of study required. I have heard various quotes regarding the recommended study time for each exam level, but for most people I think those estimates are on the low side.

So, enhance your chance of success by starting your studies now - you'll be glad you did when you are taking the exam!

The Performance Professional... Like a Rolling Stone, Baby...

2010-05-19T08:15:00.000-07:00

The image shown above is the album cover of the Rolling Stones' 1972 album, "Exile on Main St." Upon its initial release, this album, while enjoying substantial sales, received very mixed reviews from rock music critics. Time has viewed this album kindly, however, and the album now is generally considered to be one of the greatest rock albums of all time. The album was re-released yesterday in a remastered format with several previously unreleased demos and other features, creating quite a media buzz.

So what, you may be asking, do the Rolling Stones and this album have to do with performance measurement or the CIPM designation?

When I was growing up, for a long time my desired career choice was to become a rock radio DJ (fortunately, I did not pursue this path, as rock radio has essentially died and DJ has a completely different meaning in today's world). Thus, I like to reflect on music and related events and their broader meaning. A couple of thoughts come to mind with respect to the Rolling Stones that remind me of performance measurement.

First, when watching old interviews of the Rolling Stones, one of the things that is striking is the frequent comments that the members of the band did not set out with a plan to have a career doing rock music. They certainly did not intend to be playing music 10 years later, let alone 20, 30, 40 plus years later! Quite similar to performance analysts, really... virtually all of us that are doing performance measurement ended up doing so somewhat accidentally. Granted, the reasons we first opened our spreadsheets to calculate time-weighted returns are likely different from what drove Keith Richards to pick up a guitar... but, I think many of us share the fact that we didn't expect to be doing performance analysis 10 or 20 years later. How serendipitous for us, and Mr. Richards!

Perhaps more importantly, though, is the longevity aspect of the Rolling Stones career. People are fond of debating which band was the greatest ever - the Beatles or the Rolling Stones. I definitely favor the Beatles in that debate, as no other band (in my opinion) came close to extending rock music from a form of entertainment to a true form of artistic expression, at a critical juncture in time. But, at the same time, I think the greatest legacy of the Rolling Stones is their longevity and their professionalism. Don't be fooled by the guitars, the sneers, the leather... these guys go out on a regular basis and do what they do, and they do it well. Professionalism and doing one's job well, day-in and day-out, are so important to enabling a job that someone does to become a viable career. Musicians of many genres benefit because the Rolling Stones carry on, doing their work well.

And that is a lot of what the CIPM designation is about. Yes, we need to know how calculate returns, risk and attribution, just like a guitarist needs to know how to play certain notes, chords and techniques. But just as important, perhaps more important in the long run, is the professionalism that we bring to our daily work, and the ethics. That is how we add value to our niche and the broader investment industry, and doing so is in the long-term interest of us all.

So, see, you have more in common with Keith Richards than you might have thought...

An invite to see sample GIPS presentations

2010-05-08T09:15:00.000-07:00
I'm taking some liberties here, as this is mainly John's blog, but knowing that most of the readers probably work for firms that claim compliance with the Global Investment Performance Standards, I thought you might find this invite of interest.

Many firms struggle with their Global Investment Performance Standards (GIPS(R)) policies and procedures; and even for those who feel theirs are pretty good, there is always an opportunity for improvement.

Here's an invitation: if you send me a copy of your policies and procedures (either PDF or Word format), I'll include it with those of others who respond, and then send all participants a complete collection. I advise you to remove your firm's identity from you materials before sending it to me as I will not do any editing (you're free, of course, to include your firm's identity in the materials).

If you wish to participate, please send it to DSpaulding@SpauldingGrp.com by May 31. Only those who participate will receive the complete set.

Principles & Expert: Repetition, Repetition, Repetition...

2010-04-25T10:03:00.000-07:00

I suspect that most current CIPM candidates at both the Principles and Expert levels are about to sit for their exams this week - that's what the statistics tell us. (CFA Institute shortened the test taking window from two months to one month for this very reason, effective this period.)

You may very likely be feeling the fatigue of studying these past several weeks, and need a strategy to keep you fresh with the information over the next few days without overloading your brains.

My recommendation to you at this point is that you sit down and recite (on paper) your formulae that you are required to know for the exam. Do this as many times as you can over the next few days.

Repetition is a key to success. For this particular blog post, I chose to include a picture of Coach John Wooden (UCLA, 10 national championships). All good coaches encourage their athletes to repeat things over and over (plays, footwork, drills). One reason is to build up muscle memory, so that the body (and brain) will do what it has practiced and is accustomed to, even when exhausted or faced with adversity.

When you are sitting for the exam, you want to respond to the questions like Kobe Bryant taking a last second shot with the game on the line and a hand in his face blocking his view of the basket. You want to respond like you have been there before, hundreds of times, and as if it is second nature to you (if not first nature!).

OK, maybe a last second shot in an NBA game is over-dramatic, but you get my meaning... repeat for success!

(and, if you are looking for a good study distraction, check out www.coachwooden.com !)

Expert Level: Reading the Vignettes

2010-04-23T09:46:00.000-07:00

The structure of the Expert Level exam is 80 multiple choice questions based on 20 vignettes. Thus, for each vignette there are four questions. Each multiple choice question will have three possible answers.

Please consider this suggestion in light of your own specific test taking strategies, I suggest that you take the following approach to the vignettes:

1. Skim the vignette to get a general sense of the scenario and the subject areas touched upon.

2. Read the four questions that accompany the vignette.

3. Go back to the vignette and read it more carefully. Now that you know the questions, you will have a better idea of what to focus on.

When I sat for the Expert exam, it was in the first period that it was offered and I did not have the benefit of anyone's past experience. Thus, my first approach to the vignettes was to read them very carefully right off the bat, trying to understand them before I looked at the questions. This approach I found to ultimately be very time-consuming, and also frustrating when I discovered that there were occasionally questions that I could answer very quickly because they did not have to do with calculations (and in some cases had only a general connection to vignette).

I believe that if you follow the three steps above, you will use your time more efficiently during the exam. Unlike the Principles Exam, I think that most people will find they need most (if not all) of the allotted 3 hours to complete the exam. Every minute will count!

Principles Level: Setting up your calculator

2010-04-20T16:38:00.000-07:00

(Note: this tip applies to Expert Level candidates as well, but I presume that if you passed your Principles Level exam you must have had the calculator set the way you expect it to work!)

I generally recommend that candidates make sure to check two settings in particular on their calculators prior to the exam:

- precision
- order of operations

With respect to precision, my recommendation is that you set the number of decimal places that your calculator uses to the maximum value possible. I think it is better for you to see the answer in as "pure" a form as possible, and then you can choose to round or truncate your result, as necessary. For the Texas Instruments BA II Plus, for example, you can set the number of decimal places anywhere from 0 to 9 places.

As for order of operations, keep in mind that there are two different methods:

- chain (essentially left to right)

- algebraic

The chain mode of operation means that the calculator will perform calculations as they are entered (i.e., a literal "left to right" mode).

The algebraic mode of operation uses the following hierarchy:

1. Parentheses
2. Exponents
3. Multiplication and Division
4. Addition and Subtraction

People often use the acronym PEMDAS (Please Excuse My Dear Aunt Sally) to help them remember the hierarchy under the algebraic mode. Another (less witty) form of the mnemonic device is BEDMAS (Brackets Exponents Division Multiplication Addition Subtraction). Use whatever works!

To illustrate the difference between chain mode and algebraic mode, consider the following expression: 3 + 5 * 4.

Under chain mode, the solution is 32. (Obtained by first adding 5 to 3 to get 8, then multiplying 8 times 4).

Under algebraic mode, the solution is 23. (Obtained by multiplying 5 times 4, then adding 3).

I hesitate to give a recommendation with respect to mode of operations - you should use whatever makes sense for you. Personally, I can't see why anyone would use the chain mode unless that is the way their brain works - and if it works, I don't see a reason to change.

Most financial calculators default to the chain mode, whereas scientific calculators tend to default to the algebraic mode. All of the "allowed" calculators for your CIPM exams are financial, of course. Thus, given that (I think) most people tend to think and use in algebraic mode, you probably need to change your calculator's settings to get it to work the way you want it to on the exam.

Principles Level: Macro Attribution (risk-free rate)

2010-04-17T22:57:00.000-07:00

I received an email from a candidate that requested a repeat explanation of the answer to a question from our recent CIPM Q&A webinar, and I thought the answer is worth sharing with everyone here, as I would hate to see candidates waste their time with this particular item.

The question:

Macro Attirbution – Risk Free – how do we come up w/ fund value of 187,944,879 or 575,474 if none of below #s multiplied by .31% give # $575,474????

Exhibit 1-6

Michigan Endowment for the Performing Arts

Monthly Performance Attribution

June 20xx

Decision-Making Level (Investment Alternative)

Fund Value

Incremental Return Contribution

Incremental Value Contribution

Beginning Value

$186,419,405

—

—

Net Contributions

187,369,405

0.00%

950,000

Risk-Free Asset

187,944,879

0.31%

575,474

Asset Category

194,217,537

3.36%

6,272,658

Benchmarks

194,720,526

0.27%

502,989

Investment Managers

194,746,106

0.01%

25,580

Allocation Effects

194,816,599

0.04%

70,494

Total Fund

194,816,599

3.99%

8,397,194

The answer is: you don't. Or, rather, you can't. The reading that CFA Institute provides does not give you adequate information to calculate their value metric for the "risk-free asset" decision.

I refer you to the footnote at the bottom of page 35 in the "Evaluating Portfolio Performance" reading. The footnote indicates that the value metric of $575,474 "cannot be replicated... because the $950,000 net contribution... was not a single, beginning-of-the-month cash flow."

In other words, there was more than external cash flow and some of them did not occur at the start of the month, thus they did not grow at the risk-free rate of 0.31% for the entire month. They do not, unfortunately, give you all of the details of the external cash flows - they simply give you the answer; i.e., the value metric for the risk-free rate decision.

In our prep class, for simplicity, the example and exercise we cover assumes all cash flows occur at the end of the month, which enables candidates to calculate the metric themselves (and, presumably, gives them some comfort level that they understand this particular item.

A follow-up question that is often asked in our classes is what should the candidate do if presented with a problem with cash flows that do not occur at the start of the month. My answer is that you should prorate the growth at the risk-free rate accordingly. For example, assuming a 30 day month, if a cash flow occurred at the end of the 10th day, then the cash flow would grow at the risk-free rate for 2/3 of the month.

Expert Level - Common Themes #1: Standard Deviation, Downside Deviation and Tracking Error

2010-04-17T21:15:00.000-07:00

It may seem that the list of formulae to memorize for the CIPM Expert Level exam is quite long, but three of the risk measurement formulas are essentially three different applications of the same formula.

Expert level candidates are responsible for knowing the formulae for the following risk statistics:

standard deviation
downside deviation
tracking error
Consider the formulae for each of these:
If you accept and understand that the standard deviation formula measures variability in an account's historical returns, then downside deviation and tracking error are variations of that idea:

Downside deviation uses the same formula as standard deviation, except that it measures variability in the downside (i.e., losing returns). Losing returns are defined as those that fall below the pre-defined target return T. Thus, T replaces the average return in the standard deviation formula. The other modification to the formula is that any observations that are at or above the target return are treated as having a distance from the target of zero. We still divide by the total number of observations, N.

Tracking error measures the variability of the historical excess returns. Thus, tracking error uses the same formula as standard deviation (because it is, in fact, a standard deviation), but we are using the excess return in each period rather than the account's return in each period as the input data.

Given this, candidates have a couple of different ways to approach these formulae:

You can memorize the individual formulae
You can memorize the formula for standard deviation, and learn the three different applications for it.

Every candidate learns differently, but I recommend the latter approach be used, as it will give you a more comprehensive understanding of the material.

Principles Level: After-Tax Performance???

2010-04-14T16:14:00.000-07:00

Hopefully the mental strains of preparing for the CIPM Principles Exam ***and*** getting ready for the I.R.S. tax man on April 15th is not too much for the Principles candidates out there!

I have received a couple of questions lately regarding the CIPM Principles curriculum and what one needs to know with respect to after-tax performance.

This post should also clarify the discussion on after-tax performance during our webinar yesterday.

The following Learning Outcome Statements (LOS) were dropped from the CIPM curriculum, effective in the Spring 2010 exam window:

Calculate anticipated tax rates
Calculate pre-liquidation returns, including adjustments for nondiscretionary realized taxes
Calculate the benefit of tax loss harvesting

Thus, calculation of after-tax returns is not required.

Having said that, the following LOS remain part of the curriculum (as part of Study Session II):

Explain the major issues surrounding after-tax performance measurement
Evaluate approaches to after-tax benchmark selection
Compare and contrast the pre-liquidation and mark-to-liquidation methods for calculating after-tax performance

This change was announced to the CIPM Prep Providers back in November 2009, and the details can also be found at following link: https://www.cfainstitute.org/cipm/curriculum/curriculum_updates.html

Expert Level: Calculating the Sterling Ratio

2010-04-14T00:32:00.000-07:00

One of the questions asked during yesterday’s webinar has to do with the calculation of the Sterling Ratio:

Hello,

Attached are the screenshots to the Example and Solution in the courseware that I was referring to, which seems to be using a different methodology than what the reading material (and John) described. I’m just wondering which methodology we should be using for the exam, since the two methodologies will yield vastly different results.

Thanks.

The Sterling Ratio is covered in the "Risk" study session at the Expert Level of the CIPM curriculum. The question raised is Exercise LOS 2I from the CFA Institute's interactive courseware. I am not at liberty to include the screen shots here, but I will describe how I arrive at the solution.

The formula for the Sterling Ratio is: CompoundAnnualizedRoR / abs(AverageYearlyMaximumDrawdown – 10%)

The Sterling Ratio may be calculated as follows:

1. Geometric linking of the first year’s monthly returns results in an annual return of
-18.00%.

2. Geometric linking of the second year’s monthly returns results in an annual return of 15.99%.

3. Geometric linking of the third year’s monthly returns results in an annual return of 12.00%.

4. Geometric linking of the three annual returns results in a cumulative return of 6.53%.

5. Annualizing the cumulative return over the 3 year period results in a return of 2.13%.

6. The maximum drawdown in year 1 occurs from the start of the year through month 8. Geometrically linking the returns over this timeframe gives a drawdown (D1) of 22.24% (note that the negative is implied).

7. The maximum drawdown in year 2 occurs in month 17, which is a drawdown (D2) of 2.56%.

8. The maximum drawdown in year 3 occurs over months 29 and 30; geometric linking of the returns over those months indicates a drawdown (D3) of 3.98.

9. By adding D1, D2 and D3 and dividing the sum by 3, we get an average annual drawdown of 9.59% (again, note that the negative is implied).

It is at this point that the exercise solution seems to be in conflict with the reading entitled “Measuring the Volatility of Hedge Fund Returns” by Douglas S. Rogers and Christopher J. Van Dyke. I quote the authors:

“The challenge with the Sterling ratio is that if the average yearly maximum drawdown for any of the managers analyzed is less than the arbitrary 10%, then the denominator becomes negative and comparison with other managers with positive denominators is meaningless.”

Keep in mind that we are dealing with drawdowns, which are, by nature, negative numbers. Any negative number would be less than the “arbitrary 10%.” Thus, the statement the authors make would be pointless, unless they are referring to the absolute value of the drawdown being less than 10%.

Given my interpretation, the next steps to take to obtain the Sterling Ratio would be:

10. The numerator of the Sterling ratio is the annualized return of 2.1323%, and the denominator is abs[abs(-9.59) minus 10.00] which is equal to 0.41%. Thus the Sterling Ratio is 2.1323 / 0.41 = 5.20.

The solution to the exercise, however, shows the answer the last steps as follows:

11. The numerator of the Sterling ratio is the annualized return of 2.1323%, and the denominator is abs[-9.59 minus 10.00] which is equal to 19.59%. Thus the Sterling Ratio is 2.1323 / 19.59 = 0.11.

Quite a bit of difference in the answers! I believe this is the discrepancy in methodology that the candidate is referring to.

I believe the correct approach is to do step 10 rather than step 11. But, having said that, I will check with a couple of sources and let everyone know what I find out!

Decision-Making Level (Investment Alternative)	Fund Value	Incremental Return Contribution	Incremental Value Contribution
Beginning Value	$186,419,405	—	—
Net Contributions	187,369,405	0.00%	950,000
Risk-Free Asset	187,944,879	0.31%	575,474
Asset Category	194,217,537	3.36%	6,272,658
Benchmarks	194,720,526	0.27%	502,989
Investment Managers	194,746,106	0.01%	25,580
Allocation Effects	194,816,599	0.04%	70,494
Total Fund	194,816,599	3.99%	8,397,194