Sunday, April 25, 2010

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

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 !)

Friday, April 23, 2010

Expert Level: Reading the Vignettes

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!

Tuesday, April 20, 2010

Principles Level: Setting up your calculator

(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.

Saturday, April 17, 2010

Principles Level: Macro Attribution (risk-free rate)

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


Net Contributions




Risk-Free Asset




Asset Category








Investment Managers




Allocation Effects




Total Fund




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

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:

  1. You can memorize the individual formulae
  2. 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.

Wednesday, April 14, 2010

Principles Level: After-Tax Performance???

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:

Expert Level: Calculating the Sterling Ratio

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


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.


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

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!