In my last post regarding Investment Performance Measurement on a Single Position and Aggregations I received a comment by Carl Bacon on my web page blog (regarding this article). I have to say that I was very flattered. He wrote that “You have chosen one particular return methodology (in effect assuming cash flows occur at the start of day – not the most common)“. and I answered that “I choose it because I think it is the most intuitive especially for examples.”
But I think he’s absolutely right and that’s why I want to devote this second part exclusively to the topic of performance cash flow timing.
I have come to the conclusion that the most straightforward and also most accurate methodology is a Mixed methodology of start and end of day timing:
- Inflows are treaded as start of day (SOD)
- Outflows are treated as end of day (EOD)
Let me show you some examples:
First a simple share buy and sell transaction:
In the purchase example, where the quantity of the equity position increases quite sharply but the price fluctuations (start, buy, end) are within a range of -1%, the difference in results is quite dramatic depending on the cash flow timing method used.
The same findings are obtained with an opposite sell transaction. The simple question is whether the profit/loss is compared with the value of the position with or without cash flow. The mixed methodology always compares with the position value including cash flow and is therefore accurate in both cases.
Now I would like to apply the methodology to combinations of intraday transactions:
In the first case a fairly small position is heavily increased and decreased during the day. Start and end of day timing TWR results appear to be wrong in the outcome due to the relative low value of the position end and start of day. It is more accurate to compare the profit/loss to the position value including the intraday transactions which is achieved by applying the mixed methodology:
If the position is closed with the second sell intraday transaction, the start of day methodology is obviously wrong:
In case of a newly build position and a not full sale, the end of day methodology even results in a division by 0:
Both not intended results (-100% / DIV/0) occur in a pure intraday trading transaction with a quantity of zero start and end of day. The mixed methodology again provides an intuitive correct result as the investment is 2’090 Units and gained 10, resulting in 48 basis points:
In my opinion, the mixed methodology is suitable for all the cases described above.
Finally, here is an example that I recently encountered in one of my client projects. The client complained that the rollover of a currency swap USD/CHF for currency hedging purposes leads to a distorted performance (and finally contribution) on the USD account of a CHF client portfolio, when using start of day timing:
And yes the client is absolutely right. End of day timing would also lead to a wrong TWR (and also contribution) in the other direction. The issue is obviously that the SWAP cash flows of the forward and spot leg are quite large in comparison with the small amount on the cash account. When using the mixed methodology this can be avoided and a reasonable result will be achieved.
There may be cases that need to be handled differently, but in my opinion, the mixed methodology presented is straightforward to implement and has distinct advantages.
What do you think?
If you would like to have the examples as an Excel file please send me an email: volkmar.ritter@bicon.li