In my last post regarding Investment Performance Measurement on a Single Position and Aggregations I got a comment by Carl Bacon on my web page blog (regarding this article). I have to say that I felt 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 since it is especially for examples the most intuitive one, in my point of view“.
But I think he is absolutely right and therefore I want to dedicate this second part solely to the topic of performance cash flow timing.
I came to the conclusion that the most straight forward 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 buy example where there is rather a big increase in the quantity of the share position, but the price swings (start, buy, end) are within a -1% range, the outcome difference is quite dramatic depending on the used cash flow timing methodology. The same findings occur with an opposite sell transaction. The simple question is whether the Profit/Loss is compared to the value of the positon with or without cash flow. The mixed methodology always compares to the position value including the cash flow and therefore is accurate in both cases.
Now let me apply the methodology to combinations of intraday trading 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 point rather obviously the mixed methodology deals properly with all cases above.
Finally an example I came across recently 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 might be cases which need to be treated differently but in my point of view the presented mixed methodology is straight forward to implement and has striking advantages.
What do you think?
If you would like to have the examples as an Excel file please send me an email: firstname.lastname@example.org