Topics Related to Calculating Miscellaneous Returns

A firm may opt to report Money-Weighted Returns (MWR) instead of Time-Weighted Returns (TWR) if they have control over external cash flows and meet one of the following conditions:

• The portfolios have a closed-end, fixed life, or fixed commitment structure.
• Illiquid investments play a significant role in their investment strategy.

Annualized MWRs since inception should be calculated at least once a year. Starting from the effective date of the 2020 GIPS Standards, daily external cash flows must be considered. For periods preceding this date, external cash flows should be reflected at least quarterly. Portfolios subject to money-weighted return calculations should also be valued at least annually and as of the period-end for performance calculations.

Annualizing Returns

Returns for periods less than one year should not be annualized. Attempting to project the entire year’s investment results based on partial-year returns is not permissible.

Treatment of Cash Equivalents

Returns generated from cash and cash equivalents within portfolios must be incorporated into all total return calculations. This inclusion serves the purpose of facilitating performance assessment and allowing potential clients and consultants to evaluate the outcomes of an investment management firm. Even if another firm manages cash balances (common in manager-of-manager setups), cash and cash equivalents must still be factored into the total return calculation.

Treatment of Expenses and Fees

According to the GIPS standards, returns must be calculated after deducting transaction costs incurred during the period. Transaction costs typically include:

• Brokerage Commissions: These are negotiated fees per share for buying or selling common stock, compensating the broker for facilitating trades.
• Exchange Fees and Taxes: These are expenses associated with executing trades on exchanges and any relevant taxes.
• Bid-Offer Spreads: This represents the difference between what a dealer is willing to pay to buy a security and what they’re willing to sell it for. It accounts for the cost of liquidity and compensates for operational costs and the risk of adverse selection.

Custody Fees, on the other hand, are expenses related to the safekeeping of assets and should not be categorized as transaction costs.

When the actual transaction costs for a specific portfolio are unknown, they can be estimated. Bundled fees, often paid by some portfolios, can encompass various components, including:

• Investment Management Fees: Fees associated with managing investments.
• Transaction Costs: Expenses incurred during buying or selling investments.
• Custody Fees: Charges for the safekeeping of assets.
• Administrative Fees: Costs for administrative services.

All-in fee arrangements are common, particularly when a single company offers multiple services like asset management, brokerage, and custody. In cases where transaction costs within bundled fees cannot be separated, composites for institutional investors should reduce the gross-of-fees return by either the entire bundled fee amount or the portion that includes transaction costs.

Valuation Requirements

Firms are required to apply a fair value methodology when valuing assets. The GIPS standards define fair value as the amount at which an investment could be sold in an orderly, arm’s-length transaction between willing parties. The valuation must be determined using the objective, observable, unadjusted quoted market price for an identical investment in an active market on the measurement date, if available. Fair value must include any accrued income on fixed-income securities and all other investments that earn interest income. If objective, observable, unadjusted quoted market prices for identical investments in active markets on the measurement date are not available, the GIPS standards recommend the following alternatives, in declining order of preference:

1. Quoted prices for similar investments in active markets.
   \(\downarrow\)
2. Quoted prices for identical or similar investments in markets that are not active
   \(\downarrow\)
3. Market-based inputs, other than quoted prices, that are observable for the investment.
   \(\downarrow\)
4. Subjective, unobservable inputs.

If inputs are not available or appropriate, then investments should be valued based on the level just below the preceding level. Notice that quoted prices are the first two preferred backup options, followed by a valuation using market-based inputs or lastly, unobservable inputs.

Question

If objective, observable, unadjusted quoted market prices for identical investments in active markets on the measurement date are not available, the GIPS standards would least likely recommend which of the following alternatives?

1. Quoted prices for similar investments in active markets.
2. Market-based inputs, other than quoted prices, that are observable for the investment.
3. Quoted prices for identical or similar investments in markets that are not active.

Solution:

The correct answer is B.

Answer choice B, on the other hand, involves generating a valuation analysis based on observable market data. For instance, you might use the P/E ratios of comparable firms to estimate a company’s value or use the price per square foot of similar real estate to calculate the value of a property. This approach requires creating your valuation model rather than relying on readily available market metrics.

A and C are incorrect. They are more favorable than B because they rely on directly observable data, making them less subjective. Subjectivity can introduce room for accounting manipulation or fraudulent activities.

Reading 33: Global Investment Performance Standards

Los 33 (c) Explain the recommended valuation hierarchy of the GIPS standards