INVESTMENT PEFOMANCE COUNCIL (IPC) INVITATION TO COMMENT: Global Ivestmet Performace Stadards (GIPS ) Guidace Statemet o Calculatio Methodology The Associatio for Ivestmet Maagemet ad esearch (AIM) seeks commet o the proposed Guidace Statemet addressig calculatio methodology set forth below. For iformatio o the Guidace Statemet process, please see http://www.aimr.org/stadards/pps/process.html. Commets must be submitted i writig ad be received by AIM o later tha 31 October 2002. All commets ad replies will be put o the public record uless specifically requested. Commets should be addressed to: Professioal Stadards ad Advocacy Associatio for Ivestmet Maagemet ad esearch P.O. Box 3668 Charlottesville, Virgiia 22903 USA e: GIPS Guidace Statemet Fax: 01-434-951-5320 E-mail: stadardsettig@aimr.org AIM accepts resposes by fax or e-mail, but it would be helpful if a hardcopy respose is submitted as well. Effective Date This Guidace Statemet will apply to all firms from the Effective Date forward. The proposed Effective Date for this Guidace Statemet is 1 April 2003. This is the earliest date that the guidace ca become effective give the estimated time eeded for the public commet ad IPC approval process. O this date, the Guidace Statemet will replace all previous guidace o the subject. Executive Summary The GIPS stadards idicate specific dates i the future whe differet calculatio methodologies will be required. This Guidace Statemet provides clarificatio o the various methodologies for calculatig rates of retur ad asset-weightig portfolio returs to calculate composite returs. Commet equested AIM seeks public iput o the proposals set forth i this documet. Issues to cosider i cojuctio with this proposal iclude: Do you agree with the priciples established i the Guidace Statemet? Are all areas of rate of retur ad asset-weighted composite calculatio sufficietly covered i this Guidace Statemet? 1
Are there other areas of calculatio methodology that should be addressed i this Guidace Statemet? Is it reasoable to expect that firms will be able to value portfolios at the time of ay exteral cash flow begiig 1 Jauary 2010 (excludig real estate, veture capital, ad private equity)? Do you agree with the proposed Effective Date? If ot, whe should the guidace become effective? If commetators suggest other proposals, AIM requests that they explai the ratioale behid their proposal. 2
Adoptio Date: Effective Date: 1 April 2003 etroactive Applicatio: No INVESTMENT PEFOMANCE COUNCIL Global Ivestmet Performace Stadards (GIPS ) Guidace Statemet o Calculatio Methodologies Stadard 2.A.1: Total retur, icludig realized ad urealized gais plus icome, must be used. Stadard 2.A.2: Time-weighted rates of retur that adjust for cash flows must be used. Periodic returs must be geometrically liked. Time-weighted rates of retur that adjust for daily-weighted cash flows must be used for periods begiig 1 Jauary 2005. Actual valuatios at the time of exteral cash flows will likely be required for periods begiig 1 Jauary 2010. Stadard 2.A.3: I both the umerator ad the deomiator, the market values of fixedicome securities must iclude accrued icome. I calculatig the performace of the portfolios withi a composite, the GIPS stadards require firms to use: 1. A total rate of retur. A total retur icludes icome as well as realized ad urealized gais ad losses. Stadard 1.A.5 requires the use of accrual accoutig for fixed-icome securities ad all other assets that accrue iterest icome. Stadard 1.A.6 states that accrual accoutig must be used for divideds begiig 1 Jauary 2005. 2. A time-weighted rate of retur (T), computed usig a miimum of mothly valuatios ad adjustig for cash flows. Sub-period returs must be geometrically liked. The GIPS stadards require the use of a time-weighted rate of retur because it removes the effects of cash flows, which are geerally cliet-drive. By removig the effects of cash flows, a timeweighted rate of retur best reflects the firm s ability to maage the portfolio assets accordig to a specified strategy or objective. Calculatio methodologies that iclude adjustmets to remove the effect of cash flows from the performace retur are cosidered time-weighted rate-of-retur methods. A example of the total retur formula where o cash flows have occurred is: T ( EMV BMV ) BMV 3
T is the total retur, EMV is the market value of the portfolio at the ed of the period, icludig all icome accrued up to the ed of the period, ad BMV is the portfolio's market value at the begiig of the period, icludig all icome accrued up to the ed of the previous period. This formula represets the growth (or declie) i the value of the portfolio, icludig both capital appreciatio ad icome, as a proportio of the begiig market value with o cash flows over a period. However, most portfolios experiece cash flows. A cash flow is a exteral flow of cash ad/or securities (i.e., capital additios or withdrawals). Divided paymets ad iterest icome are ot cosidered cash flows. Uless adjustmets are made, cash flows may skew the portfolio retur. A more accurate method of calculatig idividual portfolio performace is to determie the market value of the portfolio o the date of each cash flow, calculate a rate of retur for the subperiod accordig to the precedig formula, ad geometrically lik the sub-period returs to calculate the portfolio retur for the full period. Adjustmets must, therefore, be made to accout for cash flows. The above formula also represets the same calculatio used to compute sub-period returs usig the Daily Valuatio Method, with sub-period returs geometrically liked to produce the retur for the period. Util 1 Jauary 2010, calculatio methods that approximate the effect of cash flows are acceptable. However, the philosophy of the GIPS stadards is to preset performace returs that are as accurate as practically possible. Just as the Stadards trasitio to more frequet valuatios (See, Stadard 1.A.3.), the Stadards also trasitio to more precise calculatio methodologies. Therefore, the GIPS stadards will require time-weighted rates of retur that adjust for daily-weighted cash flows by 1 Jauary 2005 ad will likely require time-weighted rates of retur with valuatios at the time of exteral cash flows by 1 Jauary 2010. Each of these methodologies is described below. Firms are permitted to iclude portfolios with differet calculatio methodologies i the same composite (provided the methodologies are permitted accordig the dates stated above). Firms must be cosistet i the methodology used for each portfolio withi the composite (e.g., firms caot chage the methodology from moth-to-moth depedig o which methodology produces the highest retur). T that adjust for cash flows (Permitted util 1 Jauary 2005) Various methods that approximate a T are curretly acceptable. The purpose of these methods is to produce as good a estimate as possible i circumstaces where daily valuatios are ot readily available. Oe example of a acceptable method is the Origial Dietz Method. Origial Dietz Method. This method approximates whe cash flows are received ito a portfolio by assumig that all cash flows occur at the midpoit of the period ad half-weights the total flows for the period. EMV BMV CF Dietz BMV + 0. 5CF 4
where BMV ad EMV are defied as above ad CF is the et cash flow for the period (cotributios to the portfolio are positive flows, ad withdrawals or distributios are egative flows). T that adjusts for daily-weighted cash flows (equired for periods after 1 Jauary 2005) Begiig 1 Jauary 2005, approximatio methods of T must iclude a daily-weighted adjustmet for cash flows that occur durig the measuremet period. Firms should calculate the retur for each period usig a deomiator that reflects the weightig of cash flows for the time they have bee ivested durig the period. This method cotrasts with other approximatio methods that may, for example, assume that all cash flows are spread evely through the moth. Examples of acceptable daily-weighted methods iclude the Modified Dietz ad Modified Iteral ate of etur (I) Methods. These methods weight each cash flow by the amout of time it is held i the portfolio. These are a estimate of the true T. Modified Dietz Method. The Modified Dietz Method improves upo the Origial Dietz Method by assumig a costat rate of retur o the portfolio durig the period, thereby elimiatig the eed to kow the value of the portfolio o the date of each cash flow. The Origial Dietz Method assumes that all cash flows occur durig the midpoit of the period. I a attempt to determie a more accurate retur, the Modified Dietz Method weights each cash flow by the amout of time it is actually held i the portfolio. The formula for estimatig the time-weighted rate of retur usig the Modified Dietz Method is MDietz EMV BMV CF BMV + i 1 ( CF ) i i where EMV ad BMV are as defied previously, CF is the et cash flows withi the period (cotributios to the portfolio are positive flows, ad withdrawals or distributios are egative flows), ad 1 ( CF i i ) is the sum of each cash flow, CF i, multiplied by its weight, i. i The weight ( i ) is the proportio of the total umber of days i the period that cash flow CF i has bee held i (or out of) the portfolio. The formula for i is i CD D CD i where CD is the total umber of caledar days i the period ad D i is the umber of caledar days sice the begiig of the period i which cash flow CF i occurred. The umerator is based o the assumptio that the cash flows occur at the ed of the day. If cash flows were assumed to occur at the begiig of the day, the umerator would be (CD-D i ) + 1. Some firms adjust for cash i-flows at the begiig of the day ad cash out-flows at the ed of the day. The key is for each firm to establish a policy ad treat cash flows cosistetly. 5
The chief advatage of the Modified Dietz Method is that it does ot require portfolio valuatio o the date of each cash flow. Its chief disadvatage is that it provides a less accurate estimate of the true time-weighted rate of retur. The estimate suffers most whe a combiatio of the followig coditios exists: (1) oe or more large cash flows occur; (2) cash flows occur durig periods of high market volatility i.e., the portfolio's returs are sigificatly o-liear. Firms should ote that approximatio methods such as the Modified Dietz Method will ot coform with the GIPS stadards begiig 1 Jauary 2010 whe the Stadards will likely require the use of calculatios methods that use actual valuatios at the time of exteral cash flows. Modified I Method. The Modified I Method (also kow as the Modified Bakers Admiistratio Istitute (BAI) Method) alters the Iteral ate of etur (I) formula by takig ito accout the timig of each cash flow, thus trasformig it from a moey-weighted calculatio method to a time-weighted method. I the Modified I approach, the I is that value of that satisfies the followig equatio: i 0 EMV F 1 + i ( ) i where EMV ad i are the same as for the Modified Dietz Method. The cash flows, F i, are also the same as with the Modified Dietz Method with oe importat exceptio: The market value at the start of the period is also treated as a cash flow; i.e., BMV F 0. The I is obtaied by selectig values for ad solvig the equatio util the result equals EMV. For example, if three cash flows (icludig the market value at the begiig of the period as the cash flow) have occurred, the computatioal formula will have three terms: 0 1 ( 1 + ) + F ( 1 + ) + F ( ) 2 EMV F + 1 0 1 2 The first term deals with the first cash flow, F 0, which is the value of the portfolio at the begiig of the period; i is the proportio of the period that the cash flow F i was held i (or out of) the portfolio. Because F 0 is i for the whole period, 0 1. The larger the value of F i i the term, the more it will cotribute to the total, but the smaller the expoet (i.e., the value of i ), the less the term will cotribute to the sum. The usual effect is that the first term, with a large F 0 ad 0 equal to 1, will cotribute far more tha the other terms. The advatages ad disadvatages of the Modified I Method are the same as those of the Modified Dietz Method. The Modified I Method has the additioal disadvatage of requirig a iterative process solutio ad is thus less desirable tha the Modified Dietz Method whe maual calculatio is required. It is also possible to have multiple aswers if there are both positive ad egative cash flows. Calculator ad computer programs are available, however, for solvig for the Modified I. 6
T that uses actual valuatios at the time of exteral cash flows (Likely required begiig 1 Jauary 2010) The actual valuatio of the portfolio each time there is a exteral cash flow will result i the most accurate T calculatio. I practice, this requiremet ca oly be met by havig the ability to obtai daily valuatios o all portfolio holdigs o a cotiuous basis. Daily Valuatio Method. The Daily Valuatio Method calculates the true T rather tha a estimate. The Daily Valuatio Method breaks the total performace period ito sub-periods, based o the occurrece of cash flows, i order to remove the effects of the cash flows. The formula for calculatig the sub-period retur is: ( EMV BMV ) BMV where EMV is the market value of the portfolio at the ed of the sub-period, before ay cash flows i the period, but icludig accrued icome for the period. BMV is the market value at the ed of the previous sub-period (i.e., the begiig of the curret sub-period), icludig ay cash flows at the ed of the previous sub-period ad icludig accrued icome up to the ed of the previous period. The sub-period returs are the geometrically liked accordig to the followig formula: T (( 1 + ) ( 1 + )...( 1 + )) 1 1 2 where T is the total retur ad 1, 2 are the sub-period returs for sub-period 1 through respectively. Sub-period 1 exteds from the first day of the period up to ad icludig the date of the first cash flow. Sub-period 2 begis the ext day ad exteds to the date of the secod cash flow, ad so forth. The fial sub-period exteds from the day after the fial cash flow through the last day of the period. This method assumes that the cash flow is ot available for ivestmet util the begiig of the ext day. Accordigly, whe the portfolio is revalued o the date of a cash flow, the cash flow is ot reflected i the Edig Market Value, but is added to the Edig Market Value to determie the Begiig Market Value for the ext day. The chief advatage of this method is that it calculates the true time-weighted rate of retur rather tha a estimate. The major disadvatage is that it requires precise valuatio of the portfolio o the date of each cash flow, somethig that may ot be practical for some firms at this time. I practice, this meas that firms must have the ability to value portfolios o a daily basis. If all securities are ot accurately priced for each sub-period valuatio, errors geerated i the retur calculatio usig the daily valuatio method may be greater tha the errors caused by usig the approximatio methods. I such cases, it is importat to be able to correct for errors, 7
such as missed security splits, mis-pricigs, ad improperly booked trasactios, because day-today compoudig will ot correct for them automatically if there are cash flows. Sice a time-weighted rate of retur usig actual valuatios at the time of exteral cash flows will likely be required for periods begiig 1 Jauary 2010, firms usig a approximatio method will have to chage their calculatio method by that time. Geometric Likig If mothly portfolio returs are calculated, the mothly returs are liked geometrically to compute a quarterly retur usig this formula: QT (( + ) ( 1 + ) ( 1 + )) 1 1 MO1 MO2 MO3 where QT is the portfolio quarterly retur ad MO1, MO2, ad MO3 are the portfolio returs for moths 1, 2, ad 3, respectively. Similarly, to compute the aual rate of retur for portfolio returs calculated quarterly, the formula to use is (( + ) ( 1 + ) ( 1 + ) ( 1 + )) 1 Y 1 QT1 QT 2 QT 3 QT 4 where QT1, QT2, QT3, ad QT4 are composite returs for Quarters 1, 2, 3, ad 4, respectively. Alteratively, firms could geometrically lik the twelve mothly returs to calculate the aual retur. Applicatio: Example 1: Give the followig iformatio, calculate the rate of retur for this portfolio for Jauary, February, March, ad the first quarter of 1998, usig the Modified Dietz Method: Date Market Value ( ) Cash ( ) Market Value Post Cash ( ) 12/31/97 200,000 1/31/98 208,000 2/16/98 217,000 +40,000 257,000 2/28/98 263,000 3/22/98 270,000-30,000 240,000 3/31/98 245,000 8
Solutio: Jauary Ja ( 208,000 200,000) 200,000 4.00% February ( 28 16) 28 0.43 Feb ( 263,000 208,000 40,000) ( 208,000 + ( 40,000 0.43) ) 6.66% March ( 31 22) 31 0.29 Mar ( 245,000 263,000 ( 30,000) ) ( 263,000 + ( 30,000 0.29) ) 4.72% Quarter 1 QT (( 1 + 0.0400) ( 1 + 0.0666) ( 1 + 0.0472) ) 1 16.16% 1 Example 2: Give the followig iformatio, calculate the rate of retur for this portfolio for Jauary, February, March, ad the first quarter of 2000, usig the Daily Valuatio Method: Date Market Value ( ) Cash ( ) Market Value Post Cash ( ) 12/31/99 500,000 1/31/00 509,000 2/19/00 513,000 +50,000 563,000 2/28/00 575,000 3/12/00 585,000-20,000 565,000 3/31/00 570,000 Solutio: Jauary ( 509,000 500,000) 500,000 1.80% 9
February 1/31/00 2/19/00 ( 513,000 509,000) 509,000 0.79% 2/19/00 2/28/00 ( 575,000 563,000) 563,000 2.13% 1/31/00-2/28/00 (( 1 + 0.008) ( 1 + 0.021) ) 1 2.92% March FEB 2/28/00 3/12/00 ( 585,000 575,000) 575,000 1.74% 3/12/00 3/31/00 ( 570,000 565,000) 565,000 0.88% 2/28/00-3/31/00 (( 1 + 0.017) ( 1 + 0.009) ) 1 2.62% Quarter 1 QT Mar (( 1 + 0.018) ( 1 + 0.029) ( 1 + 0.026) ) 1 7.48% 1 10
Stadard 2.A.4: Composites must be asset weighted usig begiig-of-period weightigs or aother method that reflects both begiig market value ad cash flows. Discussio: A composite is a aggregatio of idividual portfolios or asset classes represetig similar ivestmet objectives or strategies. The objective i calculatig the composite returs is to use a method that will produce the same value as if the assets of all the idividual portfolios i the composite were aggregated ad a retur is calculated for oe master portfolio. The GIPS stadards are based o the priciple of asset-weighted returs. For example, if a composite cotais two portfolios, oe of which is te times the size of the other, the rate of retur for the larger portfolio should have more impact o the composite retur tha that of the smaller portfolio. The asset-weighted retur method accomplishes this by weightig each portfolio s cotributio to the composite rate of retur by its begiig market value (as a percetage of the composite s begiig market value). The Stadards require asset weightig of the portfolio returs withi a composite usig begiig-of-period weightigs, begiig-of-period market values plus weighted cash flows, or by aggregatig portfolio assets ad cash flows to calculate performace as a sigle master portfolio. The begiig market value-weighted composite retur, BMV, ca be calculated usig the formula ( BMV ) i i 1 BMV BMVTOTAL i where BMV i is the begiig market value (at the start of the period) for Portfolio i, i is the rate of retur for Portfolio i, ad BMV TOTAL is the total market value at the begiig of the period for all the portfolios i the composite. The begiig market value plus cash flow-weighted method represets a refiemet to the asset-weighted approach. Cosider the case i which oe of two portfolios i a composite doubles i market value as the result of a cotributio o the third day of a performace period. Uder the asset-weighted approach, this portfolio will be weighted i the composite based solely o its begiig market value (i.e., ot icludig the cotributio). The begiig market value plus cash flow-weighted method resolves this problem by icludig the effect of cash flows i the weightig calculatio as well as i the market values. The weightig factor is calculated usig a similar formula as the Modified Dietz Method: i, j ( CD D ) CD i, j where CD is the total umber of caledar days i the period ad D i,j is the umber of caledar days sice the begiig of the period i which cash flow j occurred i portfolio i. 11
The begiig market value plus cash flow-weighted composite retur, BMV+CF, ca be calculated as follows: BMV + CF i m ( BMVi + ( CF ) ) j i, j i j i m ( BMVi + ( CFi, j i j ) 1 1, i 1 j 1, where CF i,j is cash flow j withi the period for portfolio i (cotributios to the portfolio are positive flows, ad withdrawals or distributios are egative flows) ad i is the retur for portfolio i. The aggregate retur method combies all of the composite assets ad cash flows to calculate performace as if the composite were oe portfolio. The method is also acceptable as a assetweighted approach. Applicatio: Calculate the composite retur usig each of the three methods based o the followig data: Portfolio 1 Date Market Value ($) Cash ($) Market Value Post Cash ($) Mothly etur 11.32% 12/31/99 100,000 1/10/00 103,000 20,000 123,000 1/22/00 130,000 1/31/00 133,000 12
Portfolio 2 Date Market Value ($) Cash ($) Market Value Post Cash ($) Mothly etur 8.26% 12/31/99 500,000 1/10/00 512,000 1/22/00 530,000-70,000 460,000 1/31/00 470,000 Composite etur Begiig Market Value eightig Method: BMV ( 100,000 0.1132) + ( 500,000 0.0826) ( 100,000 + 500,000) 8.77% Begiig Market Value Plus Cash s Method: ( 31 10) POT1 POT BMV 31 31 22 ( ) 2 + CF 31 0.68 0.29 (( 100,000 + ( 20,000 0.68) ) 0.1132 ) + (( 500,000 + ( 70,000 0.29) ) 0.0826 ) (( 100,000 + ( 20,000 0.68) ) + ( 500,000 + ( 70,000 0.29) )) Aggregate Method: (Usig Modified Dietz Method) ( 31 10) Port1 Port 31 ( 31 22) 2 31 0.68 0.29 8.85% Jauary (( 133,000 + 470,000) ( 100,000 + 500,000) ( 20,000 70,000) ) ( 100,000 + 500,000 + ( 20,000 0.68) + ( 70,000 0.29) ) 8.93% 13