Thursday, April 28, 2011

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!

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