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

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!

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

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

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

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...

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

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

Join us for a Webinar on April 12


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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

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

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)

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!