## Thursday, January 14, 2010

### Carving out in 2010

I got a call this week from a firm that is trying to deal with the recent changes to the Global Investment Performance Standards (GIPS(R)) rules regarding carve-outs. As of January 1, firms that wish to use carve-outs must manage their cash separately. While this may appear to be a reasonable change, the impact is quite noticeable. This firm is just one of many, I suspect, that is now having to deal with the new reality of this change.

This firm proposed the following. Their portfolio system (Advent's Axys) can produce asset class returns (stocks, bonds, cash). They will track the cash that's being assigned to each asset class elsewhere (probably in a spreadsheet; thus, they will "manage the cash separately"). They propose to allocate the income they get from the custodian based on how the cash is assigned throughout the month. They will calculate the returns daily, by taking the proportion of each asset class that's invested, times its respective return, and sum the result. You've probably seen this formula before:

Here, the "w" represents the weight of each of the two components of the asset class (the amount invested in stocks, for example, and the amount invested in cash) divided by the total invested (cash plus stocks); "r" represents the returns of each asset class. This formula works, provided there are no cash flows. In this case, cash flows would be represented by transactions. Since we're talking daily returns, you can be sure there will be transactions occurring, thus invalidating this formula.

As for the income, the custodian doesn't pay income based on the amount that the account starts the day with but rather with what it ends the day with; thus, if cash is shifted from one asset class to another or new money arrives, the beginning value is a poor proxy for the allocation. But this is the least of our worries. The real problem, as I see it, is the inability to derive accurate returns; separate "cash buckets" are not being maintained in a manner that will make this work.

And, if you can't make the rules work, you'll have to abandon carve-outs: sorry. But, you can continue to show this information as supplemental to your GIPS compliant presentation. This may not be as attractive as what you were doing previously, but it at least is a way to continue to demonstrate your breadth of investing in the heretofore carved out components.