Sunday, October 30, 2011

Hoping for the best...

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!

Friday, October 21, 2011

Macro Attribution: Behind the Return Formulae...

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!

Sunday, October 16, 2011

Short Position Weights in Menchero Market-Neutral Attribution Framework

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

Thursday, October 13, 2011

Duties to One's Employer...?

A Principles Level candidate asked me for an interpretation of the following ethics related question from one of the practice exams:
Angela Schneider, an equity analyst at Isotonic Asset Management, joins the board of trustees of the Lightship Foundation, a large nonprofit organization. She does not inform Isotonic about this commitment because her service on the Lightship board is uncompensated and will not interfere with her regular job. In addition, she thinks that Isotonic would exert pressure on her to influence Lightship's selection of investment managers. Under the CIPM Association Standards of Professional Conduct, has Schneider violated her duty of loyalty to her employer?
A. No
B. Yes, because she must act for the benefit of Isotonic.
C. Yes, because she must disclose that she has a conflict of interest with Isotonic.

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

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

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

Thus, the correct answer is “A. No.” 

Note:  It might appear to candidates that the actions of Ms. Schneider are a violation of the “Additional Compensation Arrangements” section of the Standards of Professional Conduct under 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 another section of the Standards of Professional Conduct; i.e., “Loyalty” – thus the question is not about “Additional Compensation Arrangements.”
  •  Ms. Schneider is not compensated for her work on Lightship’s board of trustees.

Friday, October 7, 2011

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

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 fourth quarter return for the City of Kent Pension portfolio is closest to:

( )A. 4.73%.
( )B. 5.86%.
( )C. 8.07%.

The activity with the temporary account is internal cash flow activity, not external cash flow activity.  Thus, your return calculations don’t need to consider it.

Thus your answer should be 4.73%.  This is the geometric linking of 3.688% for October, -2.804% for November, 0.9615% for the first sub-period in December and 2.926% 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 breaks the month into two sub-periods.  The return for the first sub-period is 210/208 -1.  The return for the second sub-period is 
(193.5 - 210 + 22) / (210 - 22), which assumes start of day timing for cash flows.

Wednesday, October 5, 2011

Expert Level - Sample Exam Question #15

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:

  1. Did interest rates rise or fall, which would cause a price change that was negative or positive, respectively?

  2. 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.

Monday, October 3, 2011

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

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:

  1. Finding the average of all return observations under consideration.
  2. Measuring the distance of each return observation from the average return.
  3. Squaring the distances from the average return.
  4. Summing the squares.
  5. Dividing the sum by the number of observations.
  6. 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:


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!

Saturday, October 1, 2011

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

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.

Thursday, September 1, 2011

An Internal Rate of Return exercise...

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%