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The ABC’s of Measuring Stable Value Performance

What’s the best way for a plan sponsor to evaluate the success of their stable value fund?
Specifically, if a fund offers attractive book value returns, to what degree can the plan sponsor attribute the results to:

• A good investment polic
• A good investment manager, or
• Favorable interest rate levels when participants made deposits and withdrawals from the fund?

In fact, each of these facets has a material, independent effect on stable value fund returns. These are key distinctions to draw and answers to find.  However, a quick assessment of a Fund’s book value returns alone cannot decipher these distinctions. To evaluate any investment strategy, including stable value, plan sponsors should question two components:

1. Is my investment policy appropriate to meet the objectives of the fund?
2. Is my manager best suited for the assignment?

Let’s address these topics in more detail.

1. Is my investment policy appropriate to meet the objectives for the fund?

An investment policy determines the objectives and investment guidelines of the fund, by defining permitted fund investments based on:

• Duration
  What duration (average maturity) range is most appropriate to meet the fund’s return versus responsiveness objectives?  What duration will best match the fund’s liquidity profile?
• Credit quality
  What average quality and minimum quality requirements are most appropriate to meet the fund objectives?  What diversification limits by issuer and industry make sense?
• Sector
  What investment sectors will best suit the fund’s role within the DC line-up?   To what degree should the fund invest in GICs, government, corporate, mortgage-backed, and asset-backed securities?   Should the fund exclude or include below investment grade or international securities?

Who decides the investment policy?  Usually the plan sponsor, not the investment manager. Stable value investment managers may help design an investment policy, but they do not usually make broad policy decisions. 

After adjusting for policy differences between funds, book value returns still mask distinctions between managers.  Understandably, many plan sponsors historically have been comfortable without transparency of investment performance because stable value funds often invest in low risk, low turnover portfolios.  They are perceived as passive investments. Yet, true passive investments mimic an index and require no manager decisions.  The insert box gives some examples of active stable value investment decisions.

Active Investment Decisions · 3 year versus 5 year · AA versus AAA · GIC versus bond · Cash versus invest · Hold versus trade · Asset backed vs.   Mortgage backed

How can a plan sponsor evaluate whether their manager has actually made good decisions?  One effective approach is to compare the manager’s returns with those of a strategy that could have been passively produced.  Many plans have already established passive book value benchmarks, such as blended GIC index or Treasury yields.  However, because of the embedded “lag effect” and “cash flow effect” of book value returns, the results of book value return comparisons will always be murky. This topic has been thoroughly addressed in previous issues of Stable Times.  Book value results do not enable a plan sponsor to differentiate one manager’s ability from another, to ensure the best choice for managing the investments. 

How can a plan sponsor evaluate whether their manager has actually made good decisions?  One effective approach is to compare the manager’s returns with those of a strategy that could have been passively produced.  Many plans have already established passive book value benchmarks, such as blended GIC index or Treasury yields.  However, because of the embedded “lag effect” and “cash flow effect” of book value returns, the results of book value return comparisons will always be murky. This topic has been thoroughly addressed in previous issues of Stable Times.  Book value results do not enable a plan sponsor to differentiate one manager’s ability from another, to ensure the best choice for managing the investments.

A market value-based approach is the solution that works.  The time-weighted total return methodology prescribed in the Performance Presentation Standards sponsored by the Association for Investment Management and Research (AIMR-PPS) is designed to get at the answers that plan sponsors should be seeking.

Total Return

The calculation of total return is based on the formula

R_TR = (MVE-MVB)/MVB

where R_TR  is the total return, MVE is the market value of the portfolio at the end of the period, including all income accrued up to the end of the period, and MVB is the portfolio's market value at the beginning of the period, including all income accrued up to the end of the previous period.

This well-known formula represents growth (or decline) in the value of a portfolio, including both capital appreciation and income, as a proportion of the starting market value.  This formula does not incorporate cash flows during the measurement period (see section below).

How to handle Traditional GICs

GICs are not readily marketable; so true market value returns are not possible. Yet, it is feasible to calculate the fair value of GICs by discounting cash flows using three simple steps outlined below.   See Table A at the end of this paper for a mathematical example.

AIMR-PPS allows flexibility in methodology, as long as the calculation method choosen represents perfomance fairly, is not misleading, and is applied consistently to all portfolios and time periods.

The fair value calculation for GICs is clearly an approximation.  Specifically,

• The discounting formula includes estimates of current spreads. This will create variations in results between managers.  However, there exist analogous situations for other asset classes that invest in privately negotiated or infrequently traded securities.
• The SVIA Task Force approach allows for the exclusion of bid-ask pricing differences when determining GIC values. The intent is to calculate fair value, not liquidation value.  Liquidation value is the objective when valuing most other asset classes, but is not necessarily appropriate for GICs which cannot be readily valued for liquidation.

Calculating the fair value of traditional GICs

Step1: Project future contract and principal payments

Step2: Track market yields and spreads as of key measurements dates¹

• Record yields of Treasuries with maturities that correspond to future contract payments
• Maintain GIC spread data, source is at manager discretion

• Use financial calculator or spreadsheet PV function

Measuring the effect of interim cash flows

The Standards seek to isolate the investment results that managers can control, while adjusting for those things that managers cannot control, such as participant cash flows.

The total rate of return calculation outlined above is a reasonable way of presenting the performance of a portfolio with no cash flows over a period.  However, the condition of no cash flows is clearly not applicable in a stable value environment with unpredictable, daily participant cash flows.

When cash flows occur, theoretically, they must be used to “buy" additional units of the portfolio at the market price on the day they are received.  Thus, the most accurate method of calculating return is to calculate the market value of the portfolio on the date of each cash flow, calculate an interim rate of return for the subperiod according to the preceding formula, and then link the subperiod returns to get the return for the month or quarter.  This approach removes the effect of each cash flow.  Methods that use this approach, or an approximation of it, are called time-weighted rate-of-return methods.

Time-Weighted Rate of Return

The AIMR-PPS standards require calculation of a time-weighted rate of return using a minimum of quarterly valuations and geometric linking of these interim returns.  Approximation methods are acceptable.

There are three methods to compute time-weighted rate of return.  The first is the daily valuation method (or valuation whenever cash flows occur), which is most precise and therefore considered the ideal.  Two other methods - the modified Dietz method and the modified Bank Administration Institute (BAI) method - result in approximations of the daily valuation method.   Only the daily valuation and modified Dietz method are included in this article.

Whichever method is chosen, being consistent is important. 

Daily valuation method.  The daily valuation method uses the market value of the portfolio whenever cash flows occur. The chief advantage of this method is that it calculates the true time-weighted rate of return rather than an estimate.  The major drawback is that it requires precise market valuation of the portfolio on the date of each cash flow, something that is not always feasible or practical.

The formula is

,

where S₁, S₂…, S_n are the subperiod indexes for subperiods 1, 2, etc., through n.  Subperiod 1 extends from the first day of the period up to and including the date of the first cash flow.  Subperiod 2 begins the next day and extends to the date of the second cash flow and so forth.  The final subperiod extends from the day after the final cash flow through the last day of the period.

Each of the subperiod indexes is calculated using the formula

where MVEi is the market value of the portfolio at the end of subperiod i, before any cash flows in period i but including accrued income for the period, and MVBi is the market value at the end of the previous subperiod (i.e., the beginning of this subperiod), including any cash flows at the end of the previous subperiod and including accrued income up to the end of the previous period.  See Table A for a simplified mathematical example.

Modified Dietz method. The Dietz method overcomes the need to know the market valuation of the portfolio on the date of each cash flow by assuming a constant rate of return on the portfolio during the period. The chief advantage of the modified Dietz method is that it does not require portfolio market valuation for the date of each cash flow.  Its chief disadvantage is that it provides a less accurate estimate of the true time-weighted rate of return.

The original Dietz method assumed that all cash flows occurred at the midpoint of the period.  The modified Dietz method weights each cash flow by the amount of time it is held in the portfolio.  The formula for estimating the time-weighted rate of return using the modified Dietz method is:

where MVE and MVB are as defined previously, F is the sum of the cash flows within the period (contributions to the portfolio are positive flows, and withdrawals or distributions are negative flows), and FW is the sum of each cash flow, F, multiplied by its weight, Wi.

Weight Wi is the proportion of the total number of days in the period that cash flow Fi has been in (or out of) the portfolio.  The formula for Wi is:

where CD is the total number of days in the period and Di is the number of days since the beginning of the period in which cash flow Fi occurred.  The numerator is based on the assumption that the cash flows occur at the end of the day. If cash flows were assumed to occur at the beginning of the day, the numerator would be CD + 1 - Di.

While this paper addressed measuring performance, the next installment will cover the ABC’s of presenting stable value performance. It will include:

• Composite construction
• Presentation of results
• Disclosures

See Table A.

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